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The University of Manchester Manchester Business School

Risk 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.

A. DECLARATION This work has not previously been accepted in substance for any degree and is not being concurrently submitted in candidature for any degree. Signed. Mohamed Abdulla Ebrahim Student number: 7396184 Date 4th April 2011 STATEMENT 1 The dissertation being submitted in partial fulfilment of the requirements for the degree of MBA Signed. Mohamed Abdulla Ebrahim Student number: 7396184 Date 4th April 2011 STATEMENT 2 This dissertation is the result of my own independent work/investigation, except where otherwise stated. Other sources are acknowledged by footnotes giving explicit references. A bibliography is appended. Signed. Mohamed Abdulla Ebrahim Student number: 7396184 Date 4th April 2011

STATEMENT 3 I hereby give my consent for my dissertation, if accepted, to be available for photocopying, interlibrary loans and for electronic access, and for the title and summary to be made available to outside organizations. Signed. Mohamed Abdulla Ebrahim Student number: 7396184 Date 4th April 2011

B. ACKNOWLEDGEMENTS I would like to dedicate this work to Caliph/Imam Hassan Ibne Ali (A.S) fifth (5th) and last of the Rightly Guided (Rashidun) Caliphs, the essence of whose lifes work was to preserve the unity of the Ummah of his grandfather the Prophet Mohamed (PBUH), the cost of which included his abdicating from the role of Caliph to preserve this unity. One of his sayings which inspires me and which I would like to share is Teach others your knowledge and learn the knowledge of other, so you will bring your knowledge to perfection and learn something you did not know. I would like acknowledge the support and contributions of my family and friends who influenced, encouraged and supported me to do this excellent MBA. I would like to mention the contribution 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 the process of attaining the Manchester MBA, namely Ernst & Young, Mombasa, Kenya, and Credo Investments FZE, Dubai, UAE under whose employ I completed most of the academic coursework 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 project and 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 undermine any school of thought/individual, as its objective is to increase knowledge.

Mohamed Abdulla Ebrahim April 2011

C. ABSTRACT Islamic finance (Capital Markets, Banking and Insurance) has emerged from a niche financial market to the mainstream of finance. The geographic market, clientele served, products base and volume of funds have grown significantly. Furthermore, the players have increased and now include not only pure Islamic institutions but also hybrid players (conventional bank with Islamic Finance windows). Therefore, not understanding the unique risks of the Islamic Finance model (risk sharing and risk pooling) can cause a failure of the model igniting a financial crises with a ripple effect on the Islamic faith. Hence, managing these unique risks is extremely important.

Purpose / Perceived Value To increase the academic knowledge base on Risk Management in Islamic Financial Institutions and hope some useful insights would be obtained which in turn would lead to improvement in risk management practices in Islamic Financial Institutions. This would explore the subject of corporate risk management in the context of Islamic Financial Institutions, which are run on the Islamic legal and economic system, which prohibits Riba (interest), avoids Gharar (uncertainty), avoids Maysir (gambling or excessive speculation).


Review material on risk management, Islamic finance and risk management in Islamic financial institutions and their basis in academic and professional knowledge already written on. Analyse disclosures in annual financial statements of three Islamic Financial Institutions and apply these against a Risk Management framework. Carry out a Linkedin based pilot research survey on Risk Management practices in Islamic Financial Institutions.

TABLE OF CONTENTS S/No Title/Chapter Cover page A B C 1 2 3 4 5 6 7 8 Acknowledgements Declaration Abstract Introduction Risk Management Islamic Finance Importance of Risk Management in Islamic Financial Institutions Analysis of Risk Management disclosures in Financial Statements Analysis of responses from Linkedin pilot survey questioner Conclusions and Recommendations for Further Work Bibliography From Page 0 1 2 3 5 11 18 27 39 52 59 63 To Page 0 1 2 3 10 17 26 38 51 58 62 63

Chapter 1: Introduction 1.1 Background Risk Management is gaining momentum as a subject and a professional discipline in its own right as distinct from Corporate Governance, Internal Audit/control, Financial Reporting and Regulatory compliance to which it is closely aligned with. This has become pertinent as the recent global financial crises (late 2007 to 2009) which has caused the deepest recession since the Great depression which started in 1929 and continued to throughout the 1930s, has been seen widely as a failure of financial institutions to manage the risks they undertook while transacting business.

Islamic Finance has been one of the fastest growing segments of the financial sector. At one time a common fallacy was Islamic Finance was less riskier than conventional finance, due to the maxims of al-kharaj bil dhaman and al-ghunm bil ghurm, which basically propagate the principle of no risk no gain, very much underline the recognition of risk elements in Islamic finance. (Zaid Ibrahim & Company)1. This dissertation shall endeavour to reflect the view that Islamic Finance is simply different with its own unique set of risks which are neither more or less riskier than other forms of finance. A study undertaken by the International Monetary Fund (Cihak and Hesse, 2008)2 provides empirical evidences which verify that Islamic finance is not necessarily more or less risky than conventional finance. The study points out, that by having profit-loss sharing financing, this shifts the direct credit risk from banks to their investment depositors. However, it also increases the overall degree of risk of the asset side of banks balance sheets, because it makes Islamic banks 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 use fewer risk hedging techniques and instruments (such as derivatives and swaps) than conventional banks. However, it is interesting to note that because of this prohibition against the use of derivative products and short-selling activities in the form used by its conventional counterparts, Islamic finance were largely shielded from exposure to toxic assets such as those arising from collateralised debt obligations (CDO) and credit default swaps (CDS). But all is was not well when the dust settled as Islamic Finance institutions like the Kuwait based Global Investment House was technically in solvent.

Demystifying Islamic Finance Correcting misconception, advancing value propositions Zaid Ibrahim & Co.
Islamic Banks and Financial Stability: An Empirical Analysis Martin ihk and Heiko Hesse (2008) IMF working paper 0816

1.2 Aim and Objectives The aim of this dissertation is to explore the theory and practice of risk management in the context 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 part of mainstream finance, with London vying with Dubai and Kuala Lumpur to be the Capital of Islamic Finance. It is believed that a lot of written material is available on both Islamic Finance and Risk management but much less on Risk Management practices in Islamic Financial institutions. Its aim is to show that Islamic Finance is neither more riskier nor less riskier than conventional finance, it is simply different.

The Islamic Finance model is based on social justice as articulated in the Holy Quran and the traditions, acts and sayings of Prophet Muhammad (PBUH). This system prohibits InterestRiba, excessive risk taking Gharar (Uncertainty, Risk or Speculation) is also prohibited and dealing only in activities considered Halal. In essence it is based on universal ethics flavored by a 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 Review The literature review would include among others the following sources a) Published research on both Risk Management and Islamic Finance by international organisations and professional firms like IMF, Ernst & Young etc. b) Published books on Corporate Risk Management and Islamic Finance c) Publication of articles on Islamic finance, Risk Management on the internet/websites. d) Published articles related to Risk Management in Islamic Finance in Magazines.

1.4 Research Methodology To 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 contingencies

How 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?

Corporate Risk Management Tony Merna and Faisal F Al Thani 2nd edition 2010

Part 2 Objective is to elicit opinion on way forward on improving the practice of risk management 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 Risk Report 2010 4(2009 rank in brackets), please rank the risks in your opinion as they apply to Islamic 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.

The Ernst & Young Business Risk Report 2010

1.6 Scope of Dissertation The scope of the dissertation will be to explore the risk management practices in Islamic Financial Institutions, by reviewing the currently published literature and responses on Risk Management practices and propose a way forward to improve these practices. This will be structured in chapters as described below:Chapter 2 - Risk Management This will Introduce Risk Management, exploring what risk management can achieve to enhance value to a business. Then I will introduce the concept of risk and uncertainty. Thereafter the risk management process/cycle. Finally the available tools and techniques used to mitigate, share or transfer risk. Chapter3 Islamic Finance This chapter will introduce the reader to the background and general principles governing Islamic Finance. Then each section will look at the different general products of Islamic Finance which includes Islamic Banking, Islamic Insurance Takaful and Islamic Capital markets.

Chapter 4: Importance of Risk Management in Islamic Finance This chapter will attempt to identify risks unique to the Islamic economic model, the threats posed 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 to mitigate risk depending on the context.

Chapter 5: Analysis of Risk Management disclosures in Financial Statements This chapter will present the analysis of the risk management disclosures in the financial statements of Meezan Bank based in Pakistan, Khaleej Takaful an Islamic insurance company based 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 and North Africa region.

Chapter 6: Analysis of responses from Linkedin questioner This chapter will analyse the responses from the Questioner for members of Groups on Islamic Finance on Linkedin and CIMA Islamic Finance forum on their perception of Risk Management in Islamic Finance Institutions and the Questioner for people working in Islamic Financial institutions and are members of groups in Linkedin and CIMA Islamic Finance Forum. I shall then endeavour to synthesis the findings of the analysis and suggest on the way forward to improve practice of risk management in Islamic Financial Institutions.

Chapter 7: Conclusions and Recommendations for Further Work This chapter will present a summary of the dissertation, its findings and draw conclusions. It will also attempt to suggest the way forward to improve risk management practises in Islamic Financial Institutions. Lastly it will make recommendation for further work in this area especially the interplay between corporate governance and risk management in Islamic Financial Institutions.


Chapter 2: Risk Management 2.1 Introduction This 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 the dissertation will discuss the risk management process, finally it will discuss the tools and techniques used. Risk Management has numerous definitions usually based on the context in which it is being discussed among these are: Risk management is formal process that enables the identification, assessment, planning and management of risk. 5(Merna and Al Thani 2010) COSO ERM defines enterprise risk management as a process designed to identify potential events that may effect the entity, and manage risk to be within its risk appetite, to provide reasonable assurance regarding the achievement of entity objectives. The process is effected by an entitys board of directors, management and other personnel, applied in strategy setting and across the enterprise. 6 ASNZ 4360 states that risk management is an integral part of good business practice and quality management. The standard further specifies that risk management means inter alia identifying and taking opportunities to improve performance as well as taking action to avoid or reduce the chances of something going wrong.7 The Institute of Risk Management in its risk management standard says Risk can be defined as the combination of the probability of an event and its consequences (ISO/IEC Guide 73). In all types of undertaking, there is potential for events and consequences that constitute opportunities for benefit (upside) or threats to success (downside). Risk Management is increasingly recognised as being concerned with both positive and negative aspects of risk. Therefore this standard considers risk from both perspectives.8 The common theme arising from the various definitions are that risk management is a management process to deal with uncertainties faced by any entity, threats to its resources and its consequences, as it chooses the opportunities presented by its operating environment, to increase the value of the entity.

5 6

Corporate Risk Management 2nd edition Tony Merna and Faisal F Al Thani COSO ERM 7 ASNZ 4360 8 A Risk Management Standard - (Assessed 26 February 2011)


2.2 Risks faced by an Islamic Financial institution Common risks faced by an Islamic Financial Institution are shown in Figure 2.1 (authors own) below: Risks faced by IFIs

Credit Risk

Price Risk

Profit Rate Risk

Pure Risks

Liquidity Risk

Commodity or Asset Price Risk

Exchange Rate Risk

Damage to assets

Legal Liability

Price risk is the context of an Islamic Financial Institution is that the value of the underlying commodity or asset which forms the basis of the contract between the Islamic financial institution and the financed party will vary from the original price. The exchange rate risk arises when 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 the Islamic Financial Institution as and when they fall due. This is a speculative risk undertaken with 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 as envisaged or the profit rate indicated to the institutions investment account holders will not be sufficient or balanced. Furthermore, some investment account holders benchmark this profit rate with interest rates offer by conventional banks, and can move their funds to conventional financial institutions. Liquidity risk arises due to two main reasons, firstly the inherent mismatch been the term of the source of funds (deposits which are mainly short-term) and the destination of the funds (project funding which are mainly long-term) and secondly the risk that the funds raised by the Islamic Financial Institution from the Capital markets in form of Sukuks and expected to be repaid and at 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 by damage to owned assets or property and legal liability due to being sued by third parties like customers and employees among others.


Key Drivers of Risk- Figure 2.2 (Adapted from A Risk Management Standard Institute of Risk Management) Externally Driven Financial Risks Foreign Exchange Risk Interest Rate Risk/Profit rate Credit Risks Strategic Risks Competition Customer Changes and Demands 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



The Concept of Risk and Uncertainty

Risk is simply defined as a probability of a loss or gain. One situation is riskier than another if it has a greater expected loss or a greater uncertainty (defined as the variability around the expected 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/loss varies 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 it happening and the quantum of the loss when it occurs. Uncertainty is said to exist in a business transaction whereby the decision-makers lack complete knowledge, information or understanding of the proposed transaction and its possible consequences. In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the distinction between risk and uncertainty.10Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated. The term "risk," as loosely used in everyday speech and in economic discussion, really covers two things which, functionally at least, in their causal relations to the phenomena of economic organization, are categorically different. The essential fact is that "risk" means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomenon depending on which of the two is really present and operating. ... It will appear that a measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all. We accordingly restrict the term "uncertainty" to cases of the non-quantitive type.


Risk Management & Insurance 2nd edition Harrington and Niehaus accessed on 26 February 2011



The Risk Management Process

Risk Management deals both with insurable as well as uninsurable risks and is an approach which involves a formal orderly process for systematically identifying, analysing and responding to risk events.1 (Merna & Al Thani 2010). A diagrammatic representation of the Risk Management Process Figure 2.3 adapted from A Risk Management Standard by the Institute of Risk Management4

Organisations Strategic Objectives

Risk Assessment Risk Analysis - Risk Identification - Risk Description - Risk Estimation Risk Evaluation Formal Audit


Risk Reporting: Threats and Opportunities Risk Treatment Th Residual Risk Reporting Monitoring


Risk Assessment: Is the overall process of risk analysis and risk evaluation. Risk Reporting: Threats & Opportunities to Board of Director & affected Business Managers Risk 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 management policies and the effectiveness in achieving its objectives Monitoring: This process provides assurance that there are appropriate controls in place for the organisations activities and that the procedures are understood and followed.


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 past experience. Loss severity is measured by maximum possible loss and expected loss. Hence classification of risk in accordance with these two dimensions is the starting point in managing risk. In the view of business it is sensible to focus on exposures to risks rather than the potential upside. The key exposures to risk in any organisation are physical asset exposures, legal liability exposures, human resource exposure and financial asset exposures. 2.5 Risk Management Tools and Techniques There are two major categories of risk management tools and techniques used by risk professionals to analyse risk namely Quantitative techniques and Qualitative techniques, which are applied to the dimensions of loss exposures. Qualitative techniques seek to compare the relative 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 statistical tools 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 Effect Criticality 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 and Memory Technique, Monte Carlo Simulation, Sensitivity Analysis and Probability-Impact Grid Analysis. Other techniques include Soft Systems Methodology, Utility Theory, Risk attitude and Utility Theory, Nominal Group Technique, Stress Testing and Deterministic Analysis, Tornado Diagram, Country Risk Analysis and Political Risk Analysis. Risk Control techniques include Risk Avoidance by not undertaking the activity which can lead to a loss, Loss Control which include Loss prevention (reducing the frequency of losses) and Loss reduction (reducing the severity of losses), Risk Separation this reduces the probability that several losses will at the same time , Risk Combination/pooling increases the predictability of losses through the law of large numbers and Risk Transfer which can include transferring the cause of the risk, transferring the risk itself, transferring the cause of the risk and transferring the consequence of the risk through insurance.


Contracts can be used to mitigate or transfer risk like insurance contracts for hazard (pure risks like theft, fire etc), derivative contracts (options, forwards, futures and swaps) to mitigate against financial risks like commodity prices, foreign exchange risks, interest rate risks and contracts 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 of the 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 Summary Risk management should be embedded within the organisation through the strategy and budget processes. It should be highlighted in induction and all other training and development as well as within operational processes e.g. product/service development projects. The Board has the overall responsibility for determining the strategic direction of the organisation and for creating the environment and the structures for risk management to operate effectively. There should be a risk champion on the board to ensure the board is aware of the risks under taken by the entity and decide whether these are acceptable. Business unit managers s have primary responsibility for managing risk on a day to-day basis, hence risk management should be a regular management-meeting item to allow consideration of exposures and to reprioritise work in the light of effective risk analysis. The same awareness of risk issues is also required for those involved in the audit and review of internal controls and facilitating the risk management process and includes both the internal audit function and external auditors.


Chapter 3: Islamic Finance 3.1 Introduction Islamic 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 Islamic financial institutions worldwide has risen from one institution in one country in 1975 to over 300 institutions operating in more than 75 countries (El Qorchi, 2005)11. In Sudan and Iran, the entire banking system is currently based on Islamic finance principles. However the roots of the Islamic Banking system goes back back through time to the profit and loss sharing principles in the Code of Hammurabi in the 18th century BCE. Over the centuries, philosophers and theologians alike have debated the issues surrounding justness of exchange and the charging of interest. Charging of interest is long seen as damaging to individuals as well as the economy by the majority of theologians and philosophers. Even the Christian Holy Bible and Jewish Holy Torah forbid Usury. This chapter will explore the general principle of Islamic Finance, briefly going into the sources of Islamic Law without going into the details of the various schools of thought which are contentious issues even among Islamic scholars depending on whether they are Sunni or Shia, region from which they come from (scholars from some regions are more liberal than others). There are Islamic Scholars who have approved derivative s contracts (forward, swaps and options), while other scholars consider these as unlawful. An example would be HH Prince Karim Aga Khan IV Imam to Nizari Ismaili Shia Muslims, direct lineal male descendant of the Prophet Mohamed (PBUH) and widely respected in the Muslim community 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 conventional banking institutions both in the developed and developing world, which is significantly altering the economic lives of people living in those countries. In the other end of the Shia spectrum lies the Mustali Ismaili Shia Muslims, in whose view even instalment sale contracts where the current cash price and instalment sale price differ is considered unlawful and profit loss sharing without the investor being actively involved in the business is prohibited, This based on the principle, all earnings have to be from the individuals sweat, law of one price and avoidance of excessive profit. Then it will give a birds eye view of Islamic Banking, which is a banking system that is based on the principles of Islamic law and guided by Islamic economics. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of the collection and payment of interest. Collecting interest is not permitted under Islamic law.

IMF Working Paper WP/08/16 Islamic Banks and Financial Stability: An Empirical Analysis

Prepared by Martin ihk and Heiko Hesse


Thereafter, we shall take a peek into the world of Islamic insurance Takaful, which is based on risk pooling and sharing rather than risk transfer. Takaful is where members contribute money into a pooling system in order to guarantee each other against loss or damage. Takaful is based on Islamic religious law, and is based on the responsibility of individuals to cooperate and protect each other. Lastly, it will explore Islamic Capital Markets products the most well know is the Islamic bond called a Sukuk. Since interest is prohibited Sukuks must be able to link the returns and cash flows of the financing to the assets purchased, or the returns generated from an asset purchased. This is because trading in debt is prohibited under Sharia. As such, 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 principles The guiding principles of Islamic Finance are based on Islamic Law (Sharia) as documented in the Holy Quran and promulgated in the Sunnah (Hadith - sayings and living habits/acts of Prophet Mohamed (PBUH), which are universally accepted by all Muslims. Different schools of jurisprudence both Sunni and Shia place different level of emphasis on secondary sources like Ijma (consensus of Scholars), Ijtihad (independent legal reasoning), Qiyas (analogical deduction), Aql (use intellect to find general principles applicable in the situation from the Holy Quran 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 and interpreting the Holy Quran according to the changing time and space, Urf (common practices of 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". 12 Islamic Finance is based on the prohibition of interest ("Riba"), excessive uncertainty ("Gharar") and gambling ("Maysir" or "Qimar"). Being Sharia compliant also means that the funding 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 honest fulfilment 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-nisaa: 29); shuns the use of bribery to derive undue advantage (al-baqarah: 188); and promotes clarity in contracts to minimise manipulation from dubious ambiguity (al-baqarah: 282)

12 (accessed 14th March 2011)


3.3 Islamic Banking The 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 of Europe in the 7th Century, where systems of payments and finance were required which included 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 of the Islamic state. However, this dissertation shall focus on modern Islamic banking, which is based on the following concepts - Definitions adapted from FAS 1 issued by AAOIFI13:-

Mudarabha - A partnership in profit between capital and labour. It may be conducted between investment account holders as providers of funds and the Islamic bank as a mudarib. The Islamic bank announces its willingness to accept the funds of investment amount holders, the sharing of profits being as agreed between the two parties, and the losses 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 latter cases, such losses would be borne by the Islamic bank. A Mudarabha contract may also be concluded between the Islamic bank, as a provider of funds, on behalf of itself or on behalf of investment account holders, and business owners and craftsmen.
Salam : - Purchase of a commodity for deferred delivery in exchange for immediate payment according to specified conditions or sale of a commodity for deferred delivery in exchange for immediate payment. Murabaha : - Sale of goods with an agreed upon profit mark up on the cost. Murabaha sale is of two types. In the first type, the Islamic bank purchases the goods and makes it available for sale without any prior promise from a customer to purchase it. In the second type, the Islamic bank purchases the goods ordered by a customer from a third party and then sells these goods to the same customer. In the latter case, the Islamic bank purchases the goods only after a customer has made a promise to purchase them from the bank. Musharaka : - A form of partnership between the Islamic bank and its clients whereby each party contributes to the capital of partnership in equal or varying degrees to establish a new project or share in an existing one, and whereby each of the parties becomes an owner of the capital on a permanent or declining basis and shall have his due share of profits. However,

Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) (accessed 14 March 2011)


losses are shared in proportion to the contributed capital. It is not permissible to stipulate otherwise. Istisnaa : - A contract whereby the purchaser asks the seller to manufacture a specifically defined product using the sellers raw materials at a given price. The contractual agreement of Istisna has characteristic similar to that of Salam in that it provides for the sale of a product not available at the time of sale. It also has a characteristic similar to the ordinary sale in that the price may be paid on credit; however, unlike Salam, the price in the Istisna contract is not paid when 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 and rents it to the party requiring the asset and earns rental income. In ijarah wa iktana the renter agrees to buy the asset at a nominal price at the end of the contract, in ijarah there is no such agreement to purchase the asset. 3.4 Islamic Insurance Takaful

Takaful is an Arabic word meaning guaranteeing each other. An Islamic insurance (Takaful) industry observing the rules and regulations of Islamic Sharia law has developed in recent years, which in common with Islamic banking avoids interest, excessive uncertainty and gambling. However this concept has been practiced in various forms for over 1400 years based on shared responsibility in the system of aquila as practiced between Muslims of Mecca and Medina, which laid the foundation of mutual assistance insurance Takaful based on risk pooling and sharing today. Although some Muslim scholars consider any form of insurance to be against the concept that Muslims believe in God, who is the provider and sustainer of all and is based on the following verse from the Holy Quran Who, when a misfortune overtakes them, say: 'Surely we belong to Allah and to Him shall we return'.". (Sura Al-Baqara, Verse 156) Takaful is based on the concept of social solidarity, cooperation and mutual indemnification of losses of members. It is a pact among a group of persons who agree to jointly indemnify the loss or damage that may inflict upon any of them, out of the fund they donate collectively. The Takaful contract so agreed usually involves the concepts 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


eliminating the element of uncertainty. Even though all Muslims believe in the will of Allah who is the owner of everything and we are merely his stewards, the steward had a duty to protect the assets given to him in trust by the owner, hence justification for a Sharia compliant Islamic alternative Takaful to conventional insurance. This view point for 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 and piety): 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 Narrated by Imam Ahmad bin Hanbal and Imam Abu Daud) Basis of Responsibility The place of relationships and feelings of people with faith, between each other, is just like the body; when one of its parts is afflicted with pain, then the rest of the body will be affected. (Narrated by Imam al-Bukhari and Imam Muslim) One true Muslim (Mumin) and another true Muslim (Mumin) is just like a building whereby every 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 Allahs Power, nobody will enter Paradise if he does not protect his neighbor who is in distress. (Narrated by Imam Ahmad bin Hanbal) Key Elements of Takaful Mutual 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)


3.5 Islamic capital markets There are two major components of Islamic capital markets namely Suku ks (Sharia compliant bonds) and Islamic investment funds. Using the double entry sheet terminology the Sukuk sits on the credit side of the balance sheet hence is a liability, while Islamic investment funds sit on the debit side of the balance sheet hence an asset. Both the capital market instruments are market traded on organised stock exchanges, with some restrictions on the tradability of debt instruments. Sukuk is the Arabic word for financial certificate, commonly analogous to a bond (promise to pay) in conventional finance. It is asset based rather than asset backed to comply with sharia requirements. The beauty of the Sukuk lies in asset securitisation, whereby future cash flows emanating from an asset are converted into present cash flow. A sukuk can be created on an existing asset and also on a future asset which is being created. The sukuk can be structured as Sukuk Murabaha which constitutes partial ownership in a debt, Sukuk Al Ijara which is asset backed, Sukuk Al Istisna which is project backed, Sukuk Al Musharaka which is business backed or Sukuk Al Istithmar which is an investment. From a strict sharia perspective debt certificates are not tradable at a price other than at par or face value, as any money generated from holding money is considered interest which is prohibited, hence most sukuk instruments are 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, avoids excessive uncertainty, avoid interest and is not overly speculative (gamble). These can be structured as a mutual fund, a hedge fund or electronic traded fund (ETF).

The common types of investments funds are commodity funds, equity funds, murabaha funds and Ijara funds.
Commodities funds generate profits by buying and reselling commodities. Due to the restrictions on the use of derivatives, commodities fund make use of two types of contracts: 1. Istinaa- Its 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 are similar to ethical investing funds.


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 of the cost of goods plus a profit margin. Ijara Funds acquire and keep ownership of an asset (real estate, machinery, vehicles or equipment) and then makes profits by leasing it out in return of a rental payment. The fund is responsible for the management of the assets and will earns a management fee. This is similar to Real Estate Investments Trusts (REITs) and Energy Royalty Trusts (common in Canada). 3.6 Differences between Islamic Finance and Conventional Finance instruments Sukuk and Bonds Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines a sukuk as being: Certificates of equal value representing after closing subscription, receipt of the value of the certificates and putting it to use as planned, common title to shares and rights in tangible assets, usufructs and services, or equity of a given project or equity of a special investment activity. Hence, it is a mezzanine financial instrument that is neither debt nor equity, 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 of the assets. A bond on the other hand is a contractually obligation to pay to bondholders, on certain specified dates, interest and principal. Takaful and Insurance Takaful is based on the principles on mutual assistance and voluntary contribution in a pool of funds to be shared among those in the group afflicted by perils or calamities, without guarantees that the fund will be adequate of expectation that the operator will earn a profit. In conventional insurance 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 pays premiums 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 earn interest (usury) which is forbidden in Islamic Finance. 3.7 Summary

The basic principles underlying the Islamic Finance concept are very similar to ethical investing, co-operative arrangements, and mutual principles, very closely aligned to conventional financial products but avoiding interest, excessive uncertainty and speculation.


Chapter 4: Importance of Risk Management in Islamic Finance 4.1 Introduction Product complexity in Islamic Finance has increased as there is a trend to develop an Islamic variant for most products in non-Islamic finance, but the pace in risk management practices has not developed at the same rate. This has been attributed (Ahsan Ali, December 2009)15 to the following: 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 Institutions are 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.


Risk Management Integral to the Future of Islamic Finance Article in Business Islamica December 2009


Risk management in Islamic Finance is driven by the principles of Islamic economics which are derived from the Holy Quran and Sunnah of Prophet Mohamed (PBUH). Hence it is prone to the usual risks faced by all financial institutions plus risks which affect primarily Islamic Financial Institutions. The importance of the concept of risk management in Islamic Finance is emphasised 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 by different gates. However know it well that I cannot ward off you Allahs will for none other than He has nay authority whatsoever. On Him do I put my trust and all who want to rely upon anyone 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 the Bedouin Why didnt you tie down your camel? The Bedouin answered, I put my trust in God. 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 risk affected due to its economic model or how normal business risks uniquely affect them. Then the author shall look at threats posed by these risks and consequently how those risks can be dealt with. Finally it shall discuss Islamic Financial Instruments which are used in Islamic Finance which mitigate certain risks but create a different type of risk for an IFI. 4.2 Identification of risks in the Islamic Finance economic model Credit Risk This is the risk whereby the borrower defaults on the loan. In the Islamic Financial Institutions (IFIs) context this means the counter party defaults on its contractual obligation and the IFI has to foreclose on the underlying asset, this becomes particularly challenging in the instance of residential real estate instalment sale transaction, which would conflict with its responsibility to society. It is important to note that IFIs generally have greater exposure to real estate than conventional banks, where the bank becomes owner of the asset which according to IFRS this needs to be incorporated on its balance sheet, which creates additional volatility in its reported earnings. 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 to repay of the counterparty. Market Risk Hedging 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


especially in fixed margin Murabaha (sale with profit mark up) i.e. mismatch between what is earned on the assets and what is paid out on its investment accounts. These restriction leads to artificial inflation of values of investment opportunities as too much capital is chasing too few assets. Furthermore, IFIs run a higher foreign exchange risk on their balance sheets particularly translation risk for banks with operation in multiple countries, which have to be consolidated as per IFRS requirements, due to limited opportunities to hedge. Operational Risk IFIs have to ensure correct processing and sequential documentation for most of its transactions, as any error invalidates the entire transactions and profit has to be donated. Liquidity Risk This is higher in IFIs as the secondary market for Islamic Capital market instruments is underdeveloped, due to prohibition in sale of debt at a price other than at par. Thus most Islamic Capital market instruments are held to maturity, which restricts the ability to realise cash when required repay investment account holders, hence a minor run on an IFI can have a major effect on its solvency, as it cannot access its central bank as lender of last resort. Reputational Risk This is higher in IFIs due to the risk of Sharia compliance requirements, while Sharia decrees and decisions are not standardised or follow the principles of judicial precedence as in English common law. Sharia boards are made up of scholars, who sometimes disagree on products lines like Tawaruk (Shariah-compliant of finance through which loan finance is raised by buying installments in local commodities that are owned by the bank) which is acceptable to certain scholars and prohibited by others. The Sharia board of an IFI can be changed to get scholars who are compliant to the wishes of the IFIs owners, hence they could be accused of scholar shopping or fatwa shopping which has the potential to damage its reputation in the eyes of Investment Account holders. This happened in Dubai during the recent global financial crises when some real estate developers wished to change the underlying assets of instruments in a process of consolidation of projects, which were considered unacceptable to certain scholars. Furthermore, fatwas issued by prominent scholars not on the IFIs Sharia board also tend to influence behaviour of market participants.


Classical Islamic Law 16 classified risk in into three categories as follows:1. Essential risk and al-kharj 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 sharia 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 sharia 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).


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.


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 or donations (aqood al tabarroat), the majority of jurists are of the opinion that these risks make such forms of contracts void, with the exception of Maliki jurists who view risks in contracts of gifts are permissible. From this Maliki opinion, contemporary jurists have derived that takaful is permitted 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 gambling and speculation, being some of the causes for the current global financial crisis. Short sales for instance are prohibited on the basis they fall foul of the rule on Risk of Possession; they involve the sale of something (i.e., shares) which are not owned by the seller at the time of the initial sale. Also, the sale and trading of debt falls foul of the above prohibited categories of risks as such 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 sharia does not permit a party to intentionally take on such forms of excessive risks and then to hedge against those same risks with the help of some form of hedging or risk management tool, irrespective of whether the actual hedging/risk management tool is sharia 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 tools inherent structure per se. Therefore, this type of risk can be mitigated against or avoided. 4.3 Threats posed by risks peculiar to Islamic finance

Insolvency The threat of insolvency is higher than average due by lack of liquidity in Islamic asset instruments and securities due to an under developed secondary markets and lack of access to central bank as lender of last resort in case of a run by investment account holders on the Islamic Financial Institution. This happens because of the mismatch of maturity term between Investment account deposits and the longer term financing arrangements. Also most instruments are held to maturity due to prohibition on sale of debt other than at par, so when there is a short-term liquidity crunch its effects are more severe unless its owners have funds elsewhere to provide liquidity, which the usual response is to withdraw from other markets causing a domino effect.


Reputational Damage to the Islamic Finance Brand/Segment Due to the fragmented nature of Sharia decisions and decrees, which are developed independently by scholars in different markets, without having judicial precedence requirements, with some scholars from different schools of thought being more liberal than other, widespread acceptance is difficult, especially for controversial issues. This prevents an orderly development of standards of product development and financial reporting. A point to note is that IFIs are required to confirm to the financial reporting framework of its country of operation. A general fatwa by prominent scholar not on a particular IFIs Sharia board can cause loss of credibility and confidence by the consumers if he makes a compelling argument in public about a particular transaction or product developed and IFI and approved by its Sharia board. This is a controversial issue for Islamic Credit card issuers (fixed fee based) and process on changing underlying security for a sukuk or project funding transaction in the event of real estate project consolidation on the crash in real estate market. This is compounded by lack of a universally 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 product is approved by its Sharia board, but vocally disapproved by a leading scholar, causing a reputational disaster in the perception of the public, aggravated if the scholar was a dissenting former member of the Sharia advisory board. Greater potential for volatility of reported earnings IFIs financial statements if prepared and compliant with International Financial Reporting Standards (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 the balance sheet and movement in value passing through the income statement, caused profits to fluctuate more than conventional financial institutions. This aggravates during economic downturn, as not only are the financial instruments subject to downward valuation, also losses on assets which will eventually be sold to counterparties. Operational Risk - Contracts Islamic Finance transactions are subject to multiple contracts to make them compliant with Sharia rules, the threat of misclassification of a transaction can lead to a requirement for different type of contract which if missed would negate the entire transaction i.e. making it nonSharia compliant. This is further compounded by lack suitable trained finance personnel in Sharia Law and Sharia scholars suitably trained in finance to structure Islamic Financial transactions appropriately.


4.4 How to deal with the risks identified Insolvency Insolvency caused by lack of liquidity in Islamic Financial Instruments and Sharia noncompliance of short-term funding from lender of last resort (Central Bank) could be solved by forming a supra-national body to bailout Islamic Financial Institutions funded by a voluntary donation each year say 0.2% of the member institutions operating profits. This fund could also be used to buy illiquid instruments from IFIs to finance short-term liquidity constraints, give Qardan Hasanah (interest free good loan) to IFIs for their short term liquidity needs, and operated on a mutual assistance basis. It could also act as manager of last resort to protect investment account holders funds in case of eminent collapse of a member IFI. This measure would have a positive impact on the credibility of the Islamic Finance market and improve its reputation. Qardan Hassanah mentioned in The Holy Quran 'If you lend unto Allah Qardan Hasanah , He will multiply it for you and He will forgive you, for Allah is the Most Appreciative , Most Forbearing' (Verse 64-17) Reputational Damage to the Islamic Finance Brand/Segment A supra-national co-ordinating body (possibly formed by the merger of AAOIFI and IFSB with unification of standards) which operates a global database of Islamic Financial products approved by validly constituted Sharia advisory boards, irrespective of national, sectarian or doctrinal bias, preferable based in a neutral International Financial Centre like London. This body could also have a depository of experts on Islamic Law and Finance which could review products developed which have been challenged by other scholars and considered acceptable by others by giving an independent opinion (a form of judicial review). Financial reporting for IFIs could benefit if the industry would petition the International Accounting Standards Board (IASB) to consider issuing an International Financial Reporting Standard (IFRS) for IFIs. Operational Risk Contracts This risk can be dealt with by having well reputed scholars on Sharia boards with persons with knowledge of both Islamic Law and Financial knowledge and belonging to multiple schools of thought or Islamic jurisprudence, to enable a diversified meaningful debate, when considering Islamic Products. Furthermore more personnel working within IFI should be encouraged to be certified by globally reputed Institutions like the Chartered Institute of Management Accountants17 Certificate in Islamic Finance qualification.



4.5 Islamic Financial Instruments/Transactions Risk Mitigation and Risk Creation Sukuk (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 are investing in real assets. The return on these assets takes the form of rent, and is uniformly spread over the rental period. The underlying asset provides additional security for the investor and the productivity of the asset is the basis of the return on investment. The claim embodied in Sukuk is not simply a claim to cash flow but an ownership claim. Hence, interest risk is avoided and so is the risk of the fluctuation of the value of the borrowing (as selling of debt at a price other than at par is forbidden), which mitigates the financial risk of the entity. However the ownership claim has to be reflected in the balance sheet of the IFI which results in volatility of earnings and balance sheet values due to mark to market rules required for most financial reporting frameworks. Furthermore, the prohibition of the sale of debt other than at par, prevents the development of the secondary market in these securities, creating liquidity constraints as these are not easily convertible to cash. Musharaka and Mudaraba Under these transactions the Islamic Financial Institution participates in the profit or loss of the transaction, instead of receiving interest. These transactions even though compliant with Sharia create above average credit risk, as a known amount of cash flow in form of interest is replaced by an uncertain amount of profit or loss. Derivatives Instruments in Islamic Finance This is one area which has the most controversy in Islamic Finance, as some of the hadiths used to justify derivative contracts like futures, options and forwards are challenged by many scholars, plus the lack of understanding of the workings of these instruments among Sharia scholars and the larger public. However, this dissertation would like to take the view that it is only a matter of time and financial education of Sharia scholars in the working of derivatives to hedge against market risks faced by IFIs like currency risk and commodity risk, that Sharia compliant products will gain widespread use. The main argument against derivatives are that it has excessive uncertainity (Gharar) and is gambling (Maysir). A comment in support of development of Islamic derivative products by a scholar is stated - "we should realize that even in the modern degenerated form of futures trading, some of the underlying basics concepts as well as some of the conditions for such trading are exactly the same as were laid down by the Prophet Mohamed (PBUH) for forward trading. For example, there are clear sayings of the Prophet Mohamed (PBUH) that he who makes a Salaf (forward trade) should do that for a


specific quantity, specific weight and for a specified period of time. This is something that contemporary futures trading pays particular attention to." (Fahim Khan, 1996) 18

A 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 Islamic instruments such as Derivative Securities, Istisna & Murabaha in Capital Market as of the next Iranian calendar year (March 21, 2011).19(Ali Salehabadi, Iran Daily 8th March 2011) 4.6 Summary It is well understood that Risk Management is Integral for Islamic Financial institutions, which is 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, abhors uncertainty (Gharar), and eschews gambling (Maysir), however these are not risk free. Islamic Financial Instruments mitigate against certain risks, while creating others for Islamic Financial Institutions. The effect of the recent global financial crises on Islamic Financial Institutions has been minimal, some commentators have tried to portray this as the superiority of the Islamic economic system which eschews uncertainty, interest and gambling. This is because one of the key causes was complex derivative products like credit default swap (CDS) and collateralised debt obligations (CDO) which very few people understood how they operate and the risks inbuilt in these instruments. While it is agreed that Islamic Financial Institutions would have avoided these instruments, however some Islamic Financial Institutions For example, a number of 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 during the crisis and have become technically insolvent. Plus the debt crises of Dubai and its consequent real estate market crash revealed excessive speculation. Hence, a majority of Islamic Financial Institutions while relatively immune because they were not in the centres where the financial markets were sophisticated. Furthermore, the experience of Kuwait Finance House during the Souk Al Manakh20, is a signal for Islamic Financial Institutions to be vigilant about risk management, as being Islamic will not protect them from excessive speculation.


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 2011

20 (accessed 25 March 2011)


Chapter 5: Analysis of Risk Management disclosures in Financial Statements 5.1 Introduction This chapter will look at disclosed information on Risk Management in the published financial statements 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 reference to figure 2.2 Key Drivers of Risk in Chapter 2. 5.2 Meezan Bank (Pakistan) - based on the Annual Report 2009 Meezan bank is a Pakistan based bank offering retail, corporate and investment banking services 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 those offered 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 manages the risks through a framework of risk management policies and procedures, organizational structure and risk measurement and monitoring mechanism that are closely aligned with the overall operations of the Bank. Risk management activities broadly take place at different hierarchy levels. The Board of Directors provides overall risk management supervision while the management of the Bank actively ensures that the risks are adequately identified, measured and managed. An independent and dedicated Risk Management department guided by a prudent and a robust framework of risk management policies and guidelines is in place. The Board has constituted the following committees for effective management of risks comprising of the Board members: 1. Risk Management Committee 2. Audit Committee The Risk Management Committee is responsible for reviewing and guiding risk policies and procedures and control over risk management. The Audit Committee - comprised of three nonexecutive directors - monitors compliance with the best practices of the Code of Corporate Governance and determines appropriate measures to safeguard the Bank's assets. The Board has delegated the authority to monitor and manage different risks to the specialized committees at management level. These committees are comprised of senior management team members with relevant experience and expertise, who meet regularly to deliberate on the


matters pertaining to various risk exposures under their respective supervision. Such committees include: 1. Credit Committee 2. Asset Liability Management Committee (ALCO) The Credit Committee is responsible for approving, monitoring and ensuring that financial transactions are within the acceptable risk rating criteria. Well defined policies, procedures and manuals are in place and authorities have been appropriately delegated to ensure credit quality, proper risk-reward trade off, industry diversification, adequate credit documentation and periodic credit reviews. ALCO is responsible for reviewing and recommending all market risk and liquidity risk policies and ensuring that sound risk measurement systems are established and comply with internal and regulatory requirements. The Bank applies Stress Testing and Value at Risk (VaR) techniques as market risk management tools. Contingency Funding Plan for managing liquidity crisis is in place. Liquidity management is done through cash flow matching, investment in commodity murabaha, Sukuks and placements in foreign exchange. Treasury Middle Office monitors and ensures that banks exposures are in line with the prescribed limits. The Bank ensures that the key operational risks are measured and managed in a timely and effective manner through enhanced operational risk awareness, segregation of duties, dual checks and improving early warning signals. The Bank has developed effective manuals and procedures necessary for the mitigation of operational risk. The Bank has an Internal Audit department that reports directly to the Audit Committee of the Board. Internal Audit independently reviews various functional areas of the Bank to identify control weaknesses and implementation of internal and regulatory standards. The Compliance department ensures that all directives and guidelines issued by the State Bank of Pakistan are being complied with in order to manage compliance and operational risks. The Internal Controls and Operational Risk Management Committee ensures adequate internal controls and systems are in place thereby ensuring operating efficiency. The Board has constituted a full functional audit committee. The audit committee works to ensure that the best practices of the Code of Corporate Governance are being complied by the Bank and that the policies and procedures are being complied with. The Banks risk management, compliance, internal audit and legal departments support the risk management function. The role of the risk management department is to quantify the risk and ensure the quality and integrity of the Banks risk-related data. The compliance department ensures that all the directives and guidelines issued by SBP are being complied with in order to mitigate the compliance and operational risks. Internal audit department reviews the compliance of internal control procedures with internal and regulatory standards.


RISK MANAGEMENT (Note 40) The wide variety of the Banks business activities require the Bank to identify, measure, aggregate and manage risks effectively which are constantly evolving as the business activities change in response to credit, market, product and other developments. The Bank manages the risk through a framework of risk management, policies and principles, organisational structures and risk measurement and monitoring processes that are closely aligned with the business activities of the Bank. 40.1 Credit risk The Bank manages credit risk by effective credit appraisal mechanism, approving and reviewing authorities, limit structures, internal credit risk rating system, collateral management and post disbursement monitoring so as to ensure prudent financing activities and sound financing portfolio under the umbrella of a comprehensive Credit Policy approved by the Board of Directors. The Bank also ensures to diversify its portfolio into different business segments, products and sectors. Bank take into account the risk mitigating effect of the eligible collaterals for the calculation of capital requirement for credit risk. Use of 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 Bank from 12.25% (without CRM) to 12.77% (with CRM). 40.1.2 Credit Risk - General Disclosures Basel II Specific The Bank is operating under standardised approach of Basel II for credit risk. As such risk weights for the credit risk related assets (on-balance sheet and off-balance sheet-market and non market related exposures) are assigned on the basis of standardised approach. The Bank is committed to further strengthen its risk management framework that shall enable the Bank to move ahead for adopting Foundation IRB approach of Basel II; meanwhile none of our assets class is subject to the foundation IRB or advanced IRB approaches. 40.2 Equity position risk in the banking book-Basel II Specific The Bank makes investment in variety of products/instruments mainly for the following objectives; - Investment for supporting business activities of the bank and generating revenue in short term or relatively short term tenure. - Strategic Investments which are made with the intention to hold it for a longer term and are marked as such at the time of investment.


Classification of equity investments Bank classifies its equity investment portfolio in accordance with the directives of SBP as follows: - Investments - Held for trading - Investments - Available for sale - Investments in associates - Investments in subsidiaries Some of the above mentioned investments are listed and traded in public through stock exchanges, while other investments are unlisted. Policies, valuation and accounting of equity investments The accounting policies for equity investments are designed and their valuation is carried out under the provisions and directives of State Bank of Pakistan, Securities and Exchange Commission of Pakistan and the requirements of approved International Accounting Standards as applicable in Pakistan. The investments in listed equity securities are stated at the revalued amount using market rates prevailing on the balance sheet date, while the investment in unquoted 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 profit and loss account. The surplus / (deficit) arising on revaluation of quoted securities classified as available for sale is kept in a separate account shown in the balance sheet below equity. The surplus / (deficit) arising on these securities is taken to the profit and loss account when actually realised upon disposal. The carrying value of equity investments are assessed at each balance sheet date for impairment. If the circumstances exist which indicate that the carrying value of these investments may not be recoverable, the carrying value is written down to its estimated recoverable amount. The resulting impairment loss is charged to profit and loss account. Market risk The Bank is exposed to market risk which is the risk that the value of on and off balance sheet exposures of the Bank will be adversely affected by movements in market rates or prices such as benchmark rates, profit rates, foreign exchange rates, equity prices and market conditions resulting in a loss to earnings and capital. The profit rates and equity price risk consists of two components 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 been calculated 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 changes in the value of the portfolio, if exposed to various risk factor. VaR quantifies the maximum loss that might arise due to change in risk factors, if exposure remains unchanged for a given period of time.


40.3.1 Foreign exchange risk The foreign exchange risk is the risk that the value of a financial instrument will fluctuate due to the changes in foreign exchange rates. The Bank does not take any currency exposure except to the extent of statutory net open position prescribed by SBP. Foreign exchange open and mismatch position are controlled through internal limits and are marked to market on a daily basis to contain forward exposures.

40.3.2 Equity position risk Equity position risk is the risk arising from taking long positions, in the trading book, in the equities and all instruments that exhibit market behaviour similar to equities. Counter parties limits, as also fixed by SBP, are considered to limit risk concentration. The Bank invests in those 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 Specific IRRBB includes all material yield risk positions of the Bank taking into account all relevant repricing and maturity data. It includes current balances and contractual yield rates. Bank understands that its financings shall be repriced as per their respective contracts. Regarding behaviour of non-maturity deposits, the Bank assumes that 75% of those deposits shall fall in upto one year time frame and remaining 25% of those deposits shall fall in the range of one to three years time buckets. The Bank estimates changes in the economic value of equity due to changes in the yield rates on on-balance sheet positions by conducting duration gap analysis. It also 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 risk Liquidity risk is the risk that the Bank either does not have sufficient financial resources available to meet its obligations and commitments as they fall due or can fulfil them only at excessive cost that may affect the Banks income and equity. The Bank seeks to ensure that it has access to funds at reasonable cost even under adverse conditions, by managing its liquidity risk across all class of assets and liabilities in accordance with regulatory guidelines and to take advantage of any lending and investment opportunities as they arise.


40.5 Operational risk The Bank uses Basic Indicator Approach (BIA) for assessing the capital charge for operational risk. Under BIA the capital charge is calculated by multiplying average positive annual gross income of the Bank over past three years with 15% as per guidelines issued by SBP under Basel II. To reduce losses arising from operational risk, the Bank has strengthened its risk management framework by developing polices, guidelines and manuals. It also includes set up of fraud and forgery management unit, defining responsibilities of individuals, enhancing security measures, improving efficiency and effectiveness of operations, outsourcing and improving 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 banks 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.


Corporate Risk Management 2nd Edition Merna and Thani


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 products similar 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 are summarised below.

Insurance risk The principal risk the Group faces under insurance contracts is that the actual claims and benefit payments or the timing thereof, differ from expectations. This is influenced by the frequency of claims, severity of claims, actual benefits paid and subsequent development of long-term claims. Therefore, the objective of the Group is to ensure that sufficient reserves are available to cover these liabilities. The above risk exposure is mitigated by diversification across a large portfolio of insurance contracts. The variability of risks is also improved by careful selection and implementation of underwriting strategy guidelines, as well as the use of reinsurance arrangements.

Reinsurance risk In common with other insurance companies, in order to minimize financial exposure arising from large claims, the Group, in the normal course of business, enters into agreements with other parties for reinsurance purposes. Such reinsurance arrangements provide for greater diversification of business, allow management to control exposure to potential losses arising from large risks, and provide additional capacity for growth. A significant portion of the reinsurance is effected under treaty, facultative and excess-of-loss reinsurance contracts. To minimize its exposure to significant losses from reinsurer insolvencies, the Group evaluates the financial condition of its reinsurers and monitors concentrations of credit risk arising from similar geographic regions, activities or economic characteristics of the reinsurers. Reinsurance ceded contracts do not relieve the Group from its obligations to policyholders and as a result the Group remains liable for the portion of outstanding claims reinsured to the extent that the reinsurer fails to meet the obligations under the reinsurance agreements. The two largest reinsurer account for 32% of the maximum credit exposure at 31 December 2009 (2008: 45%).


Concentration of risks The Groups insurance risk relates to policies written in the State of Qatar only. The segmental concentration of insurance risk is set out in Note 26. Sensitivity of changes in assumption The Group does not have any single insurance contract or a small number of related contracts that cover low frequency, high-severity risks such as earthquakes, or insurance contracts covering risks for single incidents that expose the Group to multiple insurance risks. The Group has adequately reinsured for insurance risks that may involve significant litigation. A 5% change in the average claims ratio will have no material impact on the consolidated statement of income (2008: same).

Financial risk The Groups principal instruments are available-for-sale investments, receivables arising from insurance and reinsurance contracts and cash and cash equivalents. The Group does not enter into derivative transactions. The main risks arising from the Groups financial instruments are interest rate risk, foreign currency risk, market price risk and liquidity risk. The board reviews and agrees policies for managing each of these risks and they are summarised below:

Regulatory framework risk Regulators are primarily interested in protecting the rights of the policyholders and monitoring these rights closely to ensure that the Group is satisfactorily managing affairs for their benefit. At the same time, the regulators are also interested in ensuring that the Group maintains an appropriate solvency position to meet unforeseen liabilities arising from economic disasters. The operations of the Group are also subject to regulatory requirements within the jurisdictions where it operates. Such regulations not only prescribe approval and monitoring of activities, but also impose certain restrictive provisions (e.g. capital adequacy) to minimize the risk of default
and insolvency on the part of the insurance companies to meet unforeseen liabilities as these arise.

Foreign currency risk Foreign currency risk is the risk that the value of a financial instrument will fluctuate due to changes in foreign exchange rates. Management believes that there is minimal risk of significant losses due to exchange rate fluctuations and consequently the Group does not hedge its foreign currency exposure. Other than balances in United States Dollars, to which the Qatari Riyal is pegged, there is no significant foreign currency financial asset due in foreign currencies included under reinsurance balances receivable.


Interest rate risk Interest rate risk arises from the possibility that changes in interest rate will affect future profitability or the fair value of financial instruments. The Group is exposed to interest rate risk on certain of its investment securities and deposits. The Group limits interest rate risk by monitoring changes in interest rates in the currencies in which its cash and interest bearing investments are denominated.

Credit risk Credit risk is the risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss. For all classes of financial assets held by the Group, the maximum credit risk exposure to the Group is the carrying value as disclosed in the consolidated statement of financial position. The Group seeks to limit its credit risk with respect to customers by monitoring outstanding receivables. Premiums and receivables comprise a large number of customers mainly within the State of Qatar. Three companies account for 14% of the receivable arising from insurance contracts as of 31 December 2009 (2008: 26%). Two reinsurance companies account for 32% of the reinsurance balances receivable as of 31 December 2009 (2008: 45%). The Group manages credit risk on its investments by ensuring that investments are only made in counter-parties that have a good credit rating. The Group does not have an internal credit rating of counter-parties and considers all counter-parties to be of the same credit quality. Unimpaired financial assets are expected, on the basis of past experience, to be fully recoverable. It is not the practice of the Group to obtain collateral over financial assets and all are, therefore, unsecured.

Liquidity risk Liquidity risk is the risk that the Group will not be able to meet its commitments associated with financial liabilities when they fall due. Liquidity requirements are monitored on regular basis and management ensures that sufficient liquid funds are available to meet any commitments as they arise. A significant amount of funds are invested in local quoted securities. The majority of time deposits held by the Group at the end of the reporting period had original maturity periods not exceeding one year.


Equity price risk Equity price risk is the risk that the value of a financial instrument will fluctuate as a result of changes in market prices, whether those changes are caused by factors specific to the individual security, or its issuer, or factors affecting all securities traded in the market. The Groups equity price risk exposure relates to financial assets whose value will fluctuate as a result of changes in market prices. The Group limits equity price risk by maintaining a diversified portfolio and by continuous monitoring of its investments. The majority of the Groups equity investments comprise securities quoted on the Qatar Exchange. A 5% change i n the prices of equities, with all other variables held constant, would impact equity by QR 14,876,376 (2008: QR 14,701,887). There would be no impact on the consolidated statement of income as all equity Investments are classified as available for sale, unless impaired.

Capital management Capital requirements are set and regulated by the Qatar Commercial Companies Law and Qatar Exchange. These requirements are put in place to ensure sufficient solvency margins. Further objectives are set by the Group to maintain a strong credit rating and healthy capital ratios in order to support its business objectives and maximise shareholders value. The Group manages its capital requirements by assessing shortfalls between reported and required capital levels on a regular basis. Adjustments to current capital levels are made in light of changes in market conditions and risk characteristics of the Group's activities. In order to maintain or adjust the capital structure, the Group may adjust the amount of dividends to shareholders or issue capital securities. The Group fully complied with the externally imposed capital requirements during the reported financial periods and no changes were made to its objectives, policies and processes from the previous year. Critical analysis There is no description of the risk management framework applied to manage risks faced by Al Khaleej Takaful i.e. whether there is a formal risk management at the operational level, the level the head of risk management report to or is part of. Part of this lack of disclosure is because there is no operating review statement as part of the annual report. The note on risk management simply refers to the management. A description of the risks faced by Al Khaleej Takaful is given in the notes to the financial statement, especially financial risk is quite detailed and it describes the business risks of Insurance and Reinsurance. However it does not delve into strategic risks, operational risk due to Sharia compliant products and hazard risks and how these are managed, mitigated or retained.


5.4 Al Baraka Banking Group (Kingdom of Bahrain- operates in Multiple countries) Al Baraka Banking Group is a Bahrain incorporated full service bank offering retail, corporate and investment banking services i.e. savings products, Investment products, credit cards, trade finance, capital raising (Sukuk) for corporate clients and sovereign governments. It operates through subsidiaries in the Middle East, North African region, South Africa and South East Asian countries. Services offered are similar to conventional banks.

Risk Management Framework (extract from Annual Report 2009 Note 25) Risk management is an integral part of the Groups decision-making process. The management risk committee and executive committees guide and assist with overall management of the Groups balance sheet risks. The Group manages exposures by setting limits approved by the Board of Directors. These risks and the processes to mitigate these risks have not significantly altered from the previous year. The most important types of risk are liquidity risk, credit risk, market risk and other operational risk. Market risk includes currency risk, equity price risk and profit rate risk. a) Liquidity risk Liquidity risk is the risk that the Group will be unable to meet its payment obligations when they fall due under normal and stress circumstances. To limit this risk, management has arranged diversified funding sources, manages assets with liquidity in mind, and monitors liquidity on regular basis. Each of the Groups subsidiaries has a documented and implemented domestic and foreign currency liquidity policies and procedures appropriate to the nature and complexity of its business. The policy addresses the subsidiaries goal of protecting financial strength even for stressful events.

b) Credit risk Credit risk is the risk that one party to a financial contract will fail to discharge an obligation and cause the other party to incur a financial loss. The Group controls credit risk by monitoring credit exposures, and continually assessing the creditworthiness of counterparties. Financing contracts are mostly secured by the personal guarantees of the individuals who own the counterparty, by collateral in form of mortgage of the objects financed or other types of tangible security. Type of credit risk Financing contracts mainly comprise Sales (Murabaha) receivables, Salam receivables, Istisnaa receivables, Mudaraba financing, Musharaka financing and Ijarah Muntahia Bittamleek.


Sales (Murabaha) receivables The Group finances these transactions through buying a commodity which represents the object of the murabaha and then resells this commodity to the murabeh (beneficiary) at a profit. The sale price (cost plus the profit margin) is repaid in instalments by the murabeh over the agreed period. The transactions are secured at times by the object of the murabaha (in case of real estate finance) and other times by a total collateral package securing the facilities given to the client. Salam receivables Salam is a contract whereby the Group makes an immediate payment to a seller for the future delivery of a commodity. To protect itself from risk associated with the commodity the Group simultaneously enters into Parallel Salam contract whereby it sells the commodity for deferred delivery for immediate payment. Istisnaa receivables Istisnaa is a sale agreement between the Group as the seller and the customer as the ultimate purchaser whereby the Group undertakes to have manufactured or acquire a goods and sell it to the customer for an agreed upon price on completion at future date. Mudaraba financing The Group enters into mudaraba contracts by investing in funds operated primarily by other banks and financial institutions for a definite period of time. Musharaka financing An agreement between the Group and a customer to contribute to a certain investment enterprise, whether existing or new, or the ownership of a certain property either permanently or according to a diminishing arrangement ending up with the acquisition by the customer of the full ownership. The profit is shared as per the agreement set between both parties while the loss is shared in proportion to their shares of capital or the enterprise. Ijarah Muntahia Bittamleek This is a lease whereby the legal title of the leased asset passes to the lessee at the end of the Ijarah (lease) term, provided that all Ijarah instalments are settled. Credit Risk Mitigation All the Groups subsidiaries, with exposures secured by real estate or other collateral carry out regular and periodic collateral verification and evaluation. This collateral verification and valuation is conducted by an independent qualified assessor or Collateral Analyst at the subsidiary. The frequency of such collateral verification is determined as a part of the credit or


investment policy and approval process. The Groups subsidiaries allow cars, ships, aircraft, satellites, railcars, and fleets as collateral for a credit and investment product but do not accept perishable assets or any other assets with depreciable life of less than five years. Subsidiaries do not accept any assets as collateral if the assets are susceptible for obsolescence in case they are moved (e.g. furniture). Subsidiaries also ensure that these assets are insured in order to be accepted as collateral. Third party cheques are accepted as collateral by the Groups subsidiaries. However, they are not eligible collateral for capital adequacy calculation. The Groups subsidiaries accept commercial papers as qualifying collateral if they are issued by banks or corporations of good credit standing. Since the maturity tenor of the commercial papers are generally short in nature (maximum of 270 days), they are not accepted as collateral for longterm facilities (i.e. the financing tenor should not exceed the commercial papers maturity tenor). The subsidiaries do not accept vehicle or equipments, if new, as qualifying collateral for more than 80% of its market value. No used vehicles or equipment, are accepted as qualifying collateral for more than 50% of its insured value. Collaterals listed hereunder may attract capital relief from capital adequacy requirements as per the Central Bank of Bahrains stipulations: 1) Hamish Jiddiyyah (HJ) (Good faith deposit): Subsidiaries take this type of collateral in the transactions for which non-binding promises to perform is given by the customer. If a customer does not honour his promise to perform, the subsidiary has recourse to the deposit. 2) Third party guarantee: The subsidiary should have recourse to the guarantor in case of customers default. In order to qualify as eligible collateral, the guarantee should be unconditional and irrevocable. The guarantor must be solvent and, if applicable of investment grade rating. 3) Urbon: This is the amount that should be taken from a purchaser or lessee when a contract is established and it is the first line of defence for the subsidiary if the purchaser or lessee breaches the contract. 4) Underlying assets of the lease contract: The underlying asset must be of monetary value and the subsidiary must have legal access to it, own it and sell it to cover the open exposure with the customers in question. The assets have also to be free of any of any kind of encumbrance. Any excess amount resulting from the closure of the pledge by the subsidiary should be returned to the customer (pledgor). The subsidiary should conduct at least annual evaluation of the pledged assets and keep adequate documentation of this evaluation. 5) Cash deposit free from any legal encumbrance with the subsidiary either in the form of restricted or unrestricted investment accounts.


6) Rated and unrated senior sukook issued by first class financial institutions or by GCC sovereigns. Credit Quality Credit Risk Management at the Group will be based upon the creation and maintenance of a Credit Rating System (CRS) for the non-retail business i.e. obligors or counterparties with more than US$663,130 in total credit facilities. All the Groups units are to incorporate into their respective credit policies the CRS as the framework for credit management taking into consideration the methodology requirements of their local central banks,in this respect. The methodology for obligor (issuer) rating will reflect the specifics of the Groups main business and the geographical diversity of its operations. Ratings of countries, governments and financial institutions are carried out in centralised fashion at the Bank in Bahrain whereas rating of corporates is done at the subsidiaries level, unless the exposure to the corporate involves crossborder risk, in which case, that rating will also be at the Bank as part of the credit limit approval. The CRS at the Bank has also been designed to be comparable to the rating system of major international rating agencies (Moodys, Standard & Poors, Fitch) in respect of their foreign currency rating of countries, governments and financial institutions. Accordingly, countries, governments and financial Institutions will be rated on the basis of their unsecured medium term foreign currency obligations. This means that for governments and financial institutions the cross-border risk will also be part of the rating and the countrys rating will be, in most cases, the ceiling on the financial institutions rating. Corporates will be rated on their senior unsecured medium term local currency obligations, unless the credit granted is across border or in foreign currency. In the latter case, the obligors countrys rating will be the ceiling on corporates rating. Where all credit to a government is in local currency, the rating for that government is the best i.e. 1 on the rating scale, however, if the exposure to the government includes foreign currency, the rating for that government will be the same as the countrys rating. A rating is a forward looking indication of creditworthiness. It is based on an evaluation of past performance, present conditions and outlook for the future. The basic approach of the major credit rating agencies to rating is the same as what the Group credit policies require i.e. a comprehensive fundamental analysis of all relevant quantitative and non quantitative factors aimed at identifying actual and potential vulnerability. Credit rating will be applied to countries and single obligors. Single obligors, in turn are categorised as financial institutions, corporates, governments and retail. CRS therefore rates obligors (issuers) and not facilities. The obligor rating of countries and single obligors will


identify the relative probability of default but will not take into account the impact of collateral security and other mitigates in the event of default. Facility ratings by contrast, combine both the probability of default and loss severity in case of defaults. However, initially the Group wide policy will be to set up obligor ratings only (which does not prevent individual subsidiaries internally to also rate facilities if they so wish). c) Concentration risk Concentrations arise when a number of counterparties are engaged in similar business activities, or activities in the same geographic region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic, political or other conditions. Concentrations indicate the relative sensitivity of the Groups performance to developments affecting a particular industry or geographical location. In order to avoid excessive concentrations of risk, the Group policies and procedures include specific guidelines to focus on country and counter party d) Market risk Market risk arises from fluctuations in profit rates, equity prices and foreign exchange rates. Under Market Risk Policies currently implemented, the management of the Group have set certain limits on the level of risk that may be accepted. This is monitored by the local management at the subsidiary level. Profit rate risk Profit rate risk is the risk that the Group will incur a financial loss as a result of mismatch in the profit rate on the Groups assets and URIA. The profit distribution to URIA is based on profit sharing agreements. Therefore, the Group is not subject to any significant profit rate risk. However, the profit sharing agreements will result in displaced commercial risk when the Groups results do not allow the Group to distribute profits inline with the market rates. Equity price risk Equity price risk is the risk that the fair values of equities decrease as the result of changes in the levels of equity indices and the value of individual stocks. The equity price risk exposure arises from the investment portfolio. The Group manages this risk through diversification of investments in terms of geographical distribution and industry concentration. The Group has total equity portfolio of US$ 362,489 thousand (2008: US$ 319,603 thousand) comprising of available for sale investments amounting to US$ 354,297 thousand (2008: US$ 294,403 thousand) and trading securities amounting to US$ 8,192 thousand (2008: US$ 25,200 thousand). Variation of 10% increase or decrease in the portfolio value will not have a significant impact on the Groups net income or equity.


Foreign exchange risk Foreign exchange risk arise from the movement of the rate of exchange over a period of time. Positions are monitored on a regular basis to ensure positions are maintained within established approved limits. Foreign currency risk sensitivity analysis In order to measure its exposures to currency risk, the Group stress tests its exposures following the standard shocks adopted by Derivatives Policy Group in this respect which calculates the effect on assets and income of the Group as a result of appreciation and depreciation in foreign currencies in relation to the reporting currency of the Group. This is done using various percentages based upon the judgement of the management of the Group. e) Operational Risk Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. Operational Risk Management Framework The Group guidelines have the following sections: (1) Operational Risk Appetite (2) Operational Risk Management Structure and Rules, (3) Risk and Control Assessment (4) Internal Audit (5) Operational Risk and Basel II and (6) Operational Risk Capital Requirement. The Groups Operational Risk Appetite is defined as the level of risk which the Group chooses to accept in its identified risk categories. Operational risk appetite is expressed in terms of both impact (direct loss) and the probability of occurrence. The Operational Risk framework will be subject to periodic Internal Audit. The Group categorizes operational risk loss events into the following categories: Infrastructure Risks Availability of information technology is of paramount importance to the Groups infrastructure. The operations of the Group and the subsidiaries might be disrupted and severe operational risks could occur and an extreme possibility is the threat of a subsidiarys existence. In order to hedge the subsidiaries from the infrastructure risk as outlined above, every subsidiary must take all the necessary measures indicated in the Business Continuity Plan and/or Disaster Recovery Plan (BCP and DRP) to cater for these risks.


Information Technology Risks The main risks that the Group is exposed to in this context is from inadequate software and hardware quality, unauthorized access by third parties or employees, etc.

Staff risk The main risks that arises from staff risks are risks due to larceny, fraud, corruption, crime, etc. In order to prevent these risks from occurring, the Group has established Group Human Resources Policies and Code of Conduct which entails constructive ways in dealing with mistakes and frauds. The Group has also established approval control steps in business processes as well as creating separate internal control processes. Further, the Group has established measures of organizational structure in terms of segregation of duties as well as diverse training measures to reduce human errors and frauds, etc.

Business risk This risk may take on the following forms: 1) Processes without clear definitions, for example, when insufficient time was spent on documenting or updating the already documented processes. 2) Outdated process descriptions in cases where reality already strongly differs from the guidelines laid down in the past. 3) The extreme case of a completely missing documentation to hedge the risk, the Group adopts sound documentation policies of business processes as it is a basic requirement for a well functioning process organization. The process description are up to date and clear; furthermore. it is made accessible to the employees in as simple way as possible. Critical Analysis There is a board risk committee, however there is no Chief Risk Officer at the board level. Head of Credit and Risk Management reports to the President and Chief executive, unlike the head of internal audit who reports to the Audit and governance committee of the board of directors. Furthermore, considering the scope of operations and size of Al Baraka banking group the role of head credit and head of risk management should be split. The group has good disclosures on the type of Islamic Financial transactions undertaken, its business risks, operational risks and some hazard risks. It could give information on strategic and reputational risks, however this non-disclosure could be justified on being sensitive confidential information especially on competitive risks. However industry structure and reputational risks could be commented on without much damage.


5.5 Tabular Comparison based on Key Risk Drivers of Risk of Disclosures Risks Meezan Bank Al Khaleej Takaful Financial Risks Foreign Exchange Risk Interest Rate Risk/Profit rate Credit Risks Liquidity and cash flow Al Baraka Banking Group

Operational Risks

Accounting controls Information systems National Culture and Regulations

Hazard Risks

Products and Services Legal Contracts Property destruction



Strategic Risks Competition Customer Changes and Demands Industry Structure Changes Research and product development X X X X X X X X X X X X

Key Disclosure made

X No disclosure made


5.6 Summary The risk management disclosures are heavily skewed towards financial risks, with Al Baraka Banking Group being the only one disclosing its transactional risk, operational risks and hazard risks. This could be attributed to the bias of the preparers of the financial statements and regulatory reporting framework which does not make these disclosures mandatory. A lamentable observation is that none of the Islamic Financial Institutions analysed had a Chief Risk Officer at board level and neither did the Head of Risk report directly to the Board of Directors or its Board Risk committee. While this is primarily a corporate governance issue (corporate governance and sound risk management are intertwined) hence, corporate boards need to be more vigilant and proactive regarding risk issues especially for boards of financial institutions. This is asserted because one of the leading shortcomings made apparent in the aftermath of the recent global financial crises was a failure of corporate boards, its advisors, employed financial professionals and external auditors was not understanding or appreciating the risks undertaken by the financial institutions. This become even more pertinent if not understanding the risk was the cause of the failure of an Islamic Financial Institution. IFIs cannot afford to take the view that they are different, which is usually the cause of hubris and decline.


Chapter 6: Analysis of responses from Linkedin Pilot Survey questioner 6.1 Introduction This chapter will analyse the responses for the pilot survey questioner put forward to groups related to Islamic Finance namely Islamic banker, Halal research council, Islamic banking and Finance, Islamic banking professionals, Islamic Finance Consultants, Advisors and Practitioners (IFCAP) , Islamic Finance Pro, Islamic Finance research and Islamic Investment and Finance requesting its members to fill in the pilot questioner to elicit their opinion on a number of issues related to Risk Management in Islamic Financial Institutions. The survey was carried out using zoomerang see links below:Part 1

Part 2 However, the response rate to the pilot survey was not great as only three (3) responses were received for part one of the pilot survey, out of seventy nine (79) visits and two (2) responses for part two of the pilot survey out of eighty seven (87) visits. Hence, all responses will be tabulated, as although the opinions will not be statistically valid but these provide qualitative insights into risk management practices in Islamic Financial Institutions. The author would like to speculate that the reason for the poor response was due to the fear of giving out confidential information rather than cover up weak risk management practices in Islamic Financial Institutions.


6.2 Questions and responses to part one of the survey Questions 1 Is there a formal process of recording potential risks, if so describe? Response 1 No Response 2 A specialized Risk Management Department is tasked with this function. 2 Who is responsible for tracking risks undertaken by the IFI (CRO, FD, CEO, CFO)? 3 Are risk specific to a individual major transactions separately identified, if so how are they added to the risk profile on the IFI Identified but no system to incorporate it into corporate risk profile Policies and guidelines have been formulated for riskrelated activities, Risk Management and Internal Audit ensures compliance. 4 How are potential risks identified in the IFI you are familiar with? By external auditors who do risk assessment as part of annual audit. Transaction risk profile is included in every major transaction and Chief Risk Officer is present in Credit Committee meetings. 5 How are the implications of the risks identified quantified? Not known Reporting systems are in place to track exposure levels. They are quantified as either manageable or disastrous. 6 Are risks quantified in accordance with how often they occur? Not known Risk Management Committee monitors key indicators regularly. Yes It is a collective responsibilities of all staff at their different levels The board and FD Chief Risk Officer Response 3 Incident report at branch level for tracking risk undertaken Risk and compliance dept based in head office Yes and they are added to the risk profile


6.2 Questions and responses in part one of the survey (continued) Questions 7 Are risks quantified as to severity i.e. potential of loss or impact on IFI? 8 To whom are these reported The annual risk Response 1 Not known Response 2 As Above, reports are automatically generated to determine value at risk. Management members sit on Risk Management/ Asset Liability Committee reporting to the Board. Board of Directors Response 3 Yes

i.e. to the Board of directors assessment by or executive management? external auditors is reported to the board 9 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, Risk reduction, Risk transfer. Risk retention. 10 How is the desirable/ acceptable level of risk determined and who determines this level? 11 How are resources allocated to ensure the overall risk level is acceptable? 12 Are contingency plans put place should the risk materialize? Not aware By Board with consultation of CEO and CFO The board of directors Risk Avoidance 10% Risk reduction 50% Risk transfer 10% Risk Retention 30

Risk Avoidance 50% Risk Reduction 10% Risk Transfer 2% Risk Retention 38%

No Answer

Policies and Guidelines

The risk dept

are approved by the Board determines the of Directors level of risk

Risk Management systems go across the board from management to managers to IT systems.

No Answer

It is included in the Policies and Guidelines.



Commentary/Critical Synthesis There has been no mention of the existence of a corporate risk register, while a branch level incident report or the Risk and compliance or Risk and Credit department could be maintaining a register, this is not very clear. Neither is it clear who at branch level coordinates risk to ensure the head office incorporates branch level transactional risks. There is a systematic quantification of risk using software calculating value at risk at regular intervals, this though commendable, needs to be understood and professional judgements made at board level (that where the buck stops), which should have a risk professional to ensure fellow board members can understand the implications. There appears to be a tendency to group risk management, with credit, internal audit, finance, compliance functions, while they have overlaps, they are separate functions on their own. IFIs with their unique types of risks should endeavour to segregate the functions. 6.3 Questions and responses on part two of the survey

Question 1 How are contingency plans communicated to the members of the organization responsible for action should the envisioned risks materialize? 2 In your opinion is the state of risk management practice adequate for the needs of the IFI, you are familiar with? 3 In your view what are the three key improvements that should be made to make the risk management process better?

Response 1 Not known

Response 2 Not known

No in my honest opinion.


A Chief Risk Officer should be appointed. An Enterprise Risk Management approach be undertaken. Improvement in communication to parties concerned about risk and how deal specific data can be incorporated.

Staff conversant with both finance and Sharia. Have a Risk management department with head of Risk at or reporting at board level.


The following are the Global Top 10 risks as Identified in The Ernst & Young Business Risk Report 2010 (2009 rank in brackets), please rank the risks in your opinion as they apply to Islamic Financial Institutions: NB: Rank 1 & 2 refer to ranking by respondent 1 and 2 1 2 3 4 5 6 7 8 9 10 Regulation and compliance (2) Access to credit/funding (1) Slow recovery or double-dip recession (No change) Managing talent (7) Emerging markets (12) Cost cutting (No change) Non-traditional entrants (5) Radical greening (4) Social acceptance risk and corporate social responsibility (New) Executing alliances and transactions (8) Rank 1 2 1 4 3 5 6 7 10 9 8 Rank 2 2 1 6 3 4 7 8 None 5 None

Commentary/Critical Synthesis From the responses it appears that communication of risk information is lacking, although everyone to a varying degree is responsible for managing risk this is an area for improvement. And risk management should be institutionalised in IFIs at all levels. The top risks even though in different order remain Access to credit/funding, regulation and compliance and managing talent. In the authors view social acceptance and corporate social responsibility should have been ranked higher for IFIs as the social mandate of Islamic economics is wider, plus reputational risk which is closely linked to social acceptance is at stake due to the value system it embraces and promotes.


6.4 Summary There appears to be a risk management department in place, in line with most financial institutions. It appears from the findings that risk management although present in different forms in Islamic Financial institutions, it is not adequate. Using the analogy of the parable of the ladder, A person being told by friends to buy a ladder, so if his roof leaks, can go up and fix it, he goes to the store gets a ladder for eight (8) feet, so now when asked by friends whether he has a ladder he says yes. After some heavy rain his roof leaks, he takes out his ladder puts it on the wall to climb to the roof, he realises that it needed a twelve (12) feet ladder.

One of the key factors supporting this view is the lack of communication, on the exact processes, it is assumed that having a Head of risk management and a risk management department takes care of all matters related to risk management. The other key issue is risk management is bundled with credit department which is an operational role, with a common head for Risk and Credit functions, hence the head of risk usually reports to Executive management i.e. does not have board level representation like the finance function nor direct board level reporting like internal audit. This situation is not satisfactory as it was observed in the aftermath of the recent global financial crises, executive management excesses can cause seemingly robust systems fail, Islamic Financial Institutions would be no exception to this human tendency. I would suggest either the Chief Risk Officer have a board seat or he reports directly to the board/board risk committee. The risk management practices and tools used are modelled on conventional financial institutions, such as credit committees, asset and liability committee, risk committee at the board level and use on value at risk measures, branch level incident registers etc. The risk profile of Islamic financial institutions are similar to conventional financial institutions, with differing emphasis on some issues like risk related to transactional contracts and compliance are higher in IFI, as they not only have to comply with the regulatory framework which all financial institutions in a country comply, but also they have to comply with rules specific to Islamic jurisprudence. However, it appears that the Sharia advisory board which is a key element in the governance structure of an Islamic Financial Institution especially related to product and transaction approval to ensure that it conforms to the tenets of the Islamic faith and jurisprudence doctrines of Sharia, is not directly involved with risk management. In the authors view as most products and transactions undertaken by IFI are similar to those in conventional finance but become


legitimate in Sharia due to a series of contracts, which comply with Islamic economic principles to enable the IFI to earn and profit and distribute the profit to its investors and owners, the Sharia advisory board should have a part to play in risk management. The product and transaction approval process to ensure compliance with Sharia, also has risks especially reputational risk, should an approved transaction be later proven to not to be compliant with Sharia, due to a small error of omission or commission in a contact. In this case the entire profit has to be forfeited to charity plus loss of reputation. Hence product and transaction risk is high due to adherence to Sharia requirements, therefore the Sharia advisory board has to have a role in risk management and the head of risk should regularly brief them.


Chapter 7: Conclusions and Recommendations for Further Work 7.1 Review of the Dissertation The first chapter is on the objectives of the research, methodology, research questions which would be asked of respondent, the scope and limitations of the dissertation. The second chapter is on the function of risk management its definitions and purposes. It also gives an overview of the tools and techniques used in the practice of risk management, the risk management process, types of risks in Islamic Financial Institutions and the key drivers of risk in any organisation. The third chapter looks at the concept of Islamic Finance, which is based on the Islamic economic model and it is based on Sharia - Islamic jurisprudence and its various schools of thought. The Islamic Finance model is based on the prohibition on interest (riba), uncertainty (gharar) and gambling (maysir). It takes a brief look at the products or type of permissible contracts which form the cornerstone of Islamic Financial products including Takaful. It then does a brief comparison of a conventional bond with a Sukuk and Insurance with Takaful. The fourth chapter is on the importance of Risk Management in Islamic Financial institutions and the basis for it in Sharia, sourced from the Quran and traditions of Prophet Mohamed (PBUH). It further looks into risk classification in accordance with classical Islamic law, the risks created by adherence to Islamic law, with a view to assert that Islamic Finance is not risk free even though it strives to avoid interest, uncertainity and gambling/excessive speculation as in conventional finance, the risks are simply different and need to be managed. The fifth chapter present an analysis of public disclosures in the financial statements of three different Islamic Financial Institutions one an Islamic bank operating in the Islamic Republic of Pakistan, the second an Islamic Insurance (Takaful) operating in the State of Qatar and the last one a Bahrain based Islamic banking group operating in mainly Muslim majority nations in Asia and Africa. These disclosures were then compared against a risk framework. The sixth chapter is on the pilot research survey on risk management practices in Islamic Financial institutions and elicit opinion of practitioners on the way forward. The survey had the expectations that in addition to the risk management practices and metrics used by conventional financial institutions would be applied to Islamic Financial Institutions in this respect the expectations were met. However the survey failed to identify risk management practices to mitigate the unique risks inherent in the Islamic economic mode, use of alternative risk management tools (derivatives prohibited) to hedge against currency risk and the contractual risk of a series of contracts in nearly every transaction should have been addressed qualitatively.


Other noteworthy findings in the second part of the survey included: Some of the respondents, in their opinion considered risk management practices in the institutions they are familiar with not to be adequate. This could be due to lack of knowledge of what the risk management department in head offices actually do, so there is a likely hood of a communication gap, which needs to be addressed as the first line of defence to manage risk is the rank and file employee. On the positive this means professionals in IFIs do know there is room for improvement and are not complacent. The top ranked risk was lack of funding/credit, hence this debunks the notion that the oil and gas money from the Middle East, has made IFIs awash with liquidity.

7.3 Conclusions Islamic Finance is growing at a phenomenal rate relative to conventional finance due to its ethical principles which are enshrined also in the Holy Bible and Holy Torah, hence it is getting acceptance worldwide. However, the practice of risk management in Islamic Finance has not kept pace. The beauty of Islamic Finance is in its partnering approach, mutual assistance and taking a long term view to its relationships with its investors and customers. The key finding was strategic risks and to an extent operating risk due to the nature of contracts, in Islamic Financial Institutions is neglected to be disclosed to the users of the financial statements. Reputational risk which is tied to social acceptance was not commented on in the financial statements as approved transactions by an institutions Sharia Advisory Board could be deemed to be prohibited by other influential Islamic scholars and jurists. This risk is very high due to the heterogeneous nature of the sources of Islamic Law. Islamic Financial Institutions need to address the issue of involving the Sharia Advisory board in its risk management process to ensure risks associated with Sharia compliance are adequately addressed and contingency plans made should there be a reputational fallout anytime in the future on a product or transaction. The key findings for improvement were that even though risk management was addressed at the board level by having a risk management committee and a head of risk, this function was attached to credit and lending, compliance and internal audit and reported to executive management, not to the board committee on risk or the full board. The other finding was that no mention was made about the role, if any, the Sharia advisory board plays in the risk management nor of them being briefed on risk management practices. The author would consider the Sharia Advisory Board as a key component of corporate governance for an Islamic


Financial Institution, who approve products and transactions which are a source of risk, should be involved in risk management. This potential neglect could be attributed to talent management i.e. lack of suitably trained Sharia scholars with an appreciation of risk management and professional risk managers with an appreciation of Sharia Law. The other major issue to address is that of talent (skills) management i.e. have trained people in risk management, finance and Islamic jurisprudence. Related to this is the segregation of risk management from operational functions like credit and asset liability management. The author would like to conclude that risk management in Islamic Financial Institutions is modelled on risk management practices in conventional financial institutions, which is commendable but not adequate to address the unique risks created by Islamic transactions. Hence the recommendation for improvements i.e. way forward should be as follows: Greater involvement of the Sharia Advisory Board in the risk management process, who should be briefing the risk management department on the risks posed by transactions and products approved, especially the Sharia Law technical parts. Training of personnel in risk management, Islamic Finance and Sharia with courses from reputed institutes the Chartered Institute of Management Accountants, and employ people working in the risk management function to have the Financial Risk Manager designation. Head to risk management function (Chief Risk Officer) to be allocated a seat in the boardroom or at a minimum direct reporting to the board or the board committee and be separated from operational functions like credit, asset and liabilities, which might compromise their objectivity. Set up a globally co-ordinating board to be a depository of all approved products and be manned by scholars from all schools of thought, who would validate Islamic finance products which comply with recognised Islamic schools of thought. They could also act as arbitrators in case of disputes and set mandatory standards to be follow by any Institution styling itself as selling Sharia compliant products. It could also play liaison role to have an International Financial Reporting Standard issued on Islamic Finance by the International Accounting Standards Board. This could be formed by the merger of AAOIFI and IFSB. Use of Islamic Sharia compliant derivatives (to be developed by Islamic Finance professionals with the help of Sharia scholars) to hedge against currency risks and other risks where conventional finance has derivatives .


A supra-national fund be set-up where member Islamic Financial Institutions contribute a percentage of their profits to act as a lender of last resort, to assist member organisation having short term cash flow problems by buying their illiquid securities, it could also extend Qardan Hassanah to members who are about to fail i.e. like a deposit protection fund and provide temporary management services to these institutions. This would signal to the global finance market that the Islamic Finance market is secure.

7.3 Recommendations for further Work This dissertation looks at the risk management function in Islamic Financial Institution, however further work is recommended on the interplay between risk management and corporate governance (both Board of Directors and Sharia Advisory Board) in Islamic Financial Institutions. Furthermore, the involvement of the Sharia advisory board in the risk management process needs to be studied and their potential inputs to the enterprise wide risk management function should be considered. Further research work need to be carried out from inside the risk management function at head office and board level to evaluate the degree of emphasis on risk management in particular organizations. Lastly the role that Islamic jurisprudence compliant derivative products could play in reducing risk in Islamic Financial Institutions could be researched.


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