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Risk Issues for Islamic

Banks

Global Islamic Finance Forum


18 September 2012

Strictly Private & Confidential


Questions to be addressed

1) Is the Risk Management Approach in Islamic Banks different from


Conventional Banks?

2) What are some of the main specific risk issues Islamic Banks face?

3) How can these be best mitigated?

4) How to find the optimal risk/return within a defined Risk Appetite


Framework?

5) Your Questions

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Risk Management Approach in Islamic Banks

Different from Conventional Banks?

- Governance
- Framework (COSO)
- Risk Culture
- Systemic Risk in
Islamic Banking?

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Generic Risks In Islamic Banking

Credit Risk

-Debt based versus Equity based

-Loss
oss given
g e Default
e au t higher
g e

-Transfer of credit risks to Investment Account Holders

-Contract Risk

-Limited
Limited Data for effective application scoring

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Generic Risks In Islamic Banking

Market Risk

-Limited hedging instruments

-Liquidity
qu d ty issues
ssues

-Valuation

-Shifting of risk from market to credit and back

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Generic Risks In Islamic Banking

Operational Risk

-Complexity higher

-Limited
ted knowledge
o edge oof staff
sta

-Processes

-Systems

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Specific Risks in Islamic Banking

-Shariah Non-Compliance risk

-Displaced
sp aced Commercial
Co e c a Risk
s

-Asset & Liability Gap Risk

-Equity Investment Risk

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Typical Balance Sheet

ASSETS LIABILITIES
RetailFinancing Restricted InvestmentAccountHolders
CorporateCommercial Financing UnrestrictedInvestmentAccountHolders
EquityBased
q y Financings/Partnerships
g / p ProfitSharingInvestmentAccounts
g
Investments (Sukuk) DemandDeposits
Shareholders

EquityInvestment
Displaced
Risk
CommercialRisk
RateofReturnRisk

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Specific Risks in Islamic Banking

Displaced Commercial Risk

The risk arising from assets managed on behalf of Investment


Account Holders which is effectively transferred to the Islamic
Financial Institutions own capital
p because the Institution forgoes
g
part or all of its Mudaribs share on such fund, when it considers
this necessary as a result of commercial pressure in order to
increase the return that would otherwise be payable to the
Investment Account Holder.
Holder IFSB(2005)

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Specific Risks in Islamic Banking

Displaced Commercial Risk

DualBankingEnvironment Commercial pressure

Due to GIA/SIA
DuetoGIA/SIA Return not guaranteed

Banksshareofprofit From equity or reserve

Relationship From borrower/lender to partner

OperationalRisk Fid i
Fiduciary risk
i k absorbed
b b db by B
Bank
k

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Profit Equalization Reserve & Investment Risk Reserve
Investment
SourcesofFunds ShareholdersFunds
Accounts

Fund Allocation
FundAllocation Assets

PER

Profit&Loss Profit/Loss Profit Loss

IRR
Profit&Loss
Bank Bank IAH
Distribution

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Specific Risks In Islamic Banking

Displaced Commercial Risk - Issues

-Non standardized practices across jurisdictions: non transparent


-Conflict of interest between shareholders and IAH. Rate of return paid
to IAH is smoothed at expense of shareholders
-But in case of PER, this could also be used to increase shareholder
dividend if desired.
-Inter-generational problem
-Appearance of steady low risk returns: false performance impression
-Might increase managements risk appetite
-Blurring key distinction between conventional and Islamic Banking

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Specific Risks In Islamic Banking

Asset & Liability Gap Risk

-Up to 4 times larger on average than at Conventional Bank


-Long (fixed) Assets versus Short (Floating) Liabilities
-Hedging
edg g issues
ssues
-But gap rapidly closing
Innovativefloatingrateproducts
ProfitSharingInvestmentAccounts
g
(RiskAbsorbent)

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Risk/Return within Set Risk Appetite

Risk Appetite

-Annually, approved by Board

-Linked
ed to st
strategy
ategy a
and
d Macro
ac o Economic
co o c Environment
o e t

-Statements across various categories


RiskOrganisation
g &Infrastructure
QualitativeRiskStatements
QuantitativeStatements
LimitStructure
Limit Structure

-Effective Communication

Originating Department Page 14


Risk/Return within Set Risk Appetite

Internal Capital Adequacy Assessment Process (ICAAP)

Economic
MaterialRisk InitialCapital
Capital
Assessment Assessment

In
nternal Capita
Definition

Capital Supply
CapitalSupply

al Planning
InternalTarget
Internal Target CapitalStress
Capital Stress
CapitalDemand
RWCR Test

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Risk Assessment
Develop comprehensive risk library

Credit Risk
CreditRisk Market Risk
MarketRisk

Equity Investment Foreign Exchange Funding Cost Liquidity


Risk/ Risk Risk
Capital Impairment
Risk Commodity Risk Credit Spread Risk

(large) Exposure Risk Equity Risk Profit Rate Risk


Banking Book
Default/Counterparty/P Option Risk
re-settlement/Delivery Displaced Commercial
Risk Profit Rate Risk Risk
Trading Book
Credit Concentration
Risk Inventory Risk

Country/Country Asset/Market Liquidity


Transfer Risk Risk

Residual/Credit Funding Liquidity Risk


Mitigation Risk

Migration Risk
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Risk Assessment

OperationalRisk

People Risk Model Risk

Technology Risk Market Driven Volume


Risk
Business
B i C
Continuity
ti it
Risk Strategic/Business
Risk
Political Risk
Reputational Risk
Regulatory/Complianc
e Risk Process Risk

Legal Risk

Systemic
y Risk

Shariah Non
Compliance Risk

Fiduciary Risk

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Materiality Assessment

For instance:
Quantitative:Netexposurerepresentsmorethan5%ofBank
Quantitative: Net exposure represents more than 5% of Banksscapitalfor
capital for
respectiveRisktype
Qualitative:Banksexpertjudgmentthatsuchriskcouldthreatensurvival
ofBank

JeroenThijs2012
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Risk/Return within Set Risk Appetite

-In combination with 3 year dynamic stress test

-Determine
ete e minimum
u cap
capital
ta needed
eeded to suppo
supportt bus
business
ess

-Decide on capital allocation and minimum required return on capital

-ICAAP then forms basis for finding optimum risk/return

Originating Department Page 19


Closing Thought

Is Islamic Banking Riskier than Conventional Banking?

Originating Department Page 20


THANK YOU

jeroen@bankislam.com.my www.bankislam.com.my

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