RISK MANAGEMENT IN ISLAMIC BANKING

Presentation by:

MAHMOOD SHAFQAT
Senior Joint Director
Islamic Banking Department

September 01, 2008

* The views expressed in this
presentation are those of the author and
do not necessarily represent State Bank
of Pakistan.
Outline
 Definition and Introduction to Risk Management
 Is Risk Management allowed under Shariah
 Risks faced by Banks
 Unique Risks faced by Islamic Banks
 Risk mitigation tools
 Regulatory Framework for Risk Management in
Pakistan
 SBP Guidelines on Risk Management in IBIs
 IFSB Standard on Capital Adequacy
Risks—Basic Concept
 Risk:
“existence of uncertainty about future outcomes”
“difference between expected and actual result”
 Uncertainty classified as general and specific
 General: ignorance of any potential outcome
 Specific: when objective/subjective probabilities can
be assigned to potential outcomes—this is usually
referred to as risk.

4
Definition of Financial Risk
 Financial risk in a banking organization is
possibility that the outcome of an action or
event could bring up adverse impacts.
 Such outcomes could either result in a
direct loss of earnings / capital or may
result in imposition of constraints on
bank’s ability to meet its business
objectives.
RISK MANAGEMENT
 Risk Management involves identification,
measurement, monitoring, reporting and
controlling risks to ensure that
 The individuals who take or manage risks clearly
understand it.
 The organization’s Risk exposure is within the limits
established by Board of Directors.
 Risk taking Decisions are in line with the business strategy
and objectives set by BOD.
 The expected payoffs compensate for the risks taken
 Risk taking decisions are explicit and clear.
 Sufficient capital as a buffer is available to take risk
Risk Management activities
 Risk management activities take place at:
 Strategic level by senior management and BOD
 Definition of risks, institutions risk appetite, formulating
strategy and policies for managing risks and establish
adequate systems and controls to ensure that overall risk
remain within acceptable level and the reward
compensate for the risk taken.
 Macro Level within a business area or across business
lines
 Risk reviews by middle management
 Micro Level where risks are actually created
 Activities performed by individuals who take risk on
organization’s behalf such as front office and loan
origination functions. Confined to following operational
procedures and guidelines set by management.
Risk management process
 Identification
 Measurement
 Monitoring
 Reporting
 Mitigation and control
 To put it simply and directly,
 ifthe bosses do not or cannot understand
both the risks and rewards in their products,
 their firm should not be in the business. -
 William J. McDonough, President, Federal Reserve Bank
of New York
Shariah Perspective
 No Risk No Reward principle (Al Ribh Bi Daman)
 So No Risk Management?
 Measures taken by Hazrat Yousuf (AS) for
drought (Ahsan ul Qasas)
 Do not give your Amwal to Sufahaa
 Writing of contracts – whether spot or deferred
(Legal risk, Documentation risk, etc)
 Maqasid-e-Shariah
 Protection of Izat, Jaan, ‘Aql, Maal, Nasl
RISKS FACED BY BANKS AND
THEIR APPLICATION ON
ISLAMIC BANKING
Risk Credit

Dimensions Liquidity
Credit
Credit
Market
Banking
Risks
Operational

Solvency

Legal/Regulatory

Systemic
ISLAMIC BANKING LESS RISKY?

 Islamic Banking is safer as it is not based

on INTEREST?
 Depositors are liable to share losses,
therefore solvency risk is mitigated?
Major Types of Risks in IB
 Credit Risk
 Attributed to delayed, deferred, and default in payments by
counterparties. Covers profit sharing contracts (Mudaraba and
Musharaka), receivables and lease (Murabaha, DM and Ijara,
Salam, Istisna’), and covers different stages of a contract
 Market Risk
 Adverse movements in interest rates, commodity prices and FX
rates. Commodity risk in Murabaha, Ijara, Salam
 Equity Risk
 Adverse changes in market value (and liquidity) of equity held for
investment purposes. Covers all equity instruments including
Mudaraba and Musharaka
Major Types of Risks in IB
 Liquidity Risk
 Adverse cash flows in situations arising mainly out of changing
market risk exposures, credit risk exposures and operational risk
exposures.
 Rate of Return Risk
 Changes in account holders’ expectations of the return on
investment. Also related to fluctuations in returns due to changes
in underlying factors of the contract.
 Operational Risk
 Inadequacy of failed processes, people and systems. Also
includes Shariah non-compliance Risk
 Legal Risk
 Inadequate legal framework, conflict of conventional and Islamic
laws and conflict between Shariah rulings and legal decisions
Credit Risk Mitigating Tools
 Pledge of assets as collateral
 Inventories, Shares, Sukuk, Units, etc.
 Third party Guarantee
 Personal Guarantee
 Promise
 Charge on deposits and assets
 Takaful
 Hamish Jiddiya
 Urbun
 Khiyar / Option
 Parallel contract, if permissible
Regulatory Framework
 Risk Management
 Guidelines on Risk Management - BSD Circular No. 7 dt. Aug. 15,
2003 
 Guidelines on Internal Credit Risk Rating Systems – BSD Circular
No. 8 dt. Oct. 29, 2007
 Risk Management Guidelines for IBIs – IBD Circular No. 1 dt.
Jan. 2, 2008.
 ICAAP Guidelines - BSD Circular 17 of 2008

 Stress Testing
 Guidelines on Stress Testing - BSD Circular No. 5 dt. Oct. 27, 2005 
 Internal Controls
 Guidelines on Internal Controls - BSD  Circular No . 7 dt. May 27,
2004 and BSD Circular No. 1 dt. Jan.14, 2006
 Policy Framework in Banks/DFIs - BSD Circular 3 of 2007  
SBP RM Guidelines for IBIs
 15 Guiding Principles
 Divided into
 General (1 Principle)
 Credit risk (4 Principles)
 Equity investment risk( 3 Principles)
 Market risk (1 Principle)
 Liquidity risk (2 Principles)
 Rate of return risk ( 2 Principles)
 Operational risk (2 Principles)
 IBIs are also exposed to reputational risk arising from
failures in governance, business strategy and process.
Negative publicity about their business practices,
particularly relating to Sharī`ah non-compliance in their
products and services, could have an impact upon their
market position, profitability and liquidity.
Guiding Principles on RM
 These principles are not radically different from
those applicable to conventional banks
 However, these are some fundamental
differences:
- Emphasis on Shariah compliance
- 6 out of 15 principles make explicit reference to
Shariah rules
1. General Requirement
 Principle 1.0: IBIs shall have in place a
comprehensive risk management and reporting
process, including appropriate board and senior
management oversight, to identify, measure,
monitor, report and control relevant categories of
risks. The process shall take into account
appropriate steps to comply with Shariah rules
and principles and to ensure the adequacy of
relevant risk reporting to the supervisory
authority.
1. General Requirement
 Board of directors (BOD) and senior
management oversight
 approve the risk management objectives,
strategies, policies and procedures
 approvals shall be communicated to all levels
 ensure the existence of an effective risk
management structure
 Sharī`ah Advisor to oversee that the IBI’s
products and activities are Sharī`ah compliant
1. General Requirement
 Board of directors (BOD) and senior
management oversight
 approve limits on aggregate financing and
investment exposures
 review the effectiveness of the risk
management activities
 Senior management shall execute the
strategic direction and set clear lines of
authority and responsibility
 Independence of risk management function
from risk taking activities
1. General Requirement
 Risk management process
 sound process for executing all elements of risk
management, including risk identification,
measurement, mitigation, monitoring, reporting and
control
 adequate system of controls with appropriate
checks and balances
(a) comply with the Sharī`ah rules and principles,
(b) comply with applicable regulatory and internal policies and
procedures; and
(c) take into account the integrity of risk management
processes
 qualityand timeliness of risk reporting available
to regulatory authorities
 appropriate and timely disclosure of information
to depositors
1. General Requirement
 Application of Emergency and Contingency Plan
 Integration of Risk Management
 Risk Measurement and use of models
 Utilization of funds
 Role of Finance Administration Department
 Management Information System for board or
senior management committee
 Human Resource: Training and development
2. Credit Risk
 Principle 2.1: IBIs shall have in place a
strategy for financing, using various
instruments in compliance with Shariah,
whereby they recognize the potential
credit exposures that may arise at different
stages of the various financing
agreements.
2. Credit Risk
 Principle 2.2: IBIs shall carry out a due diligence
review in respect of counterparties prior to deciding
on the choice of an appropriate Islamic financing
instrument.

 Principle 2.3: IBIs shall have in place appropriate

methodologies for measuring and reporting the
credit risk exposures arising under each Islamic
financing instrument.
2. Credit Risk
 Principle 2.4: IBIs shall have in place
Sharī`ah-compliant credit risk mitigating
techniques appropriate for each Islamic
financing instrument.
2. Credit risk
 These principles apply to:
- Murabaha, Salam, ijara and Istisna’ contracts
- Mudaraba and Musharaka
- Sukuk
For example, for working capital financing, Salam and
Mudaraba contracts could be used
- In case of Salam, the bank enters into a parallel Salam
contract with a third party
- What factors may effect the counterparty’s ability to
repay
2. Credit risk
 The commodity price
- Don’t use commodities with high price
volatility
- A list of all types of applicable and approved
transaction and financing
- The Islamic banks should ensure that
adequate systems and resources are
available to implement this strategy
 In case of using Mudaraba contract as a working
capital tool
- The choices of “Mudarib company” should be
made with care
2. Credit risk
 The bank must have close links with the
company - Shariah implications
- Choose an appropriate trading activity for
financing
- Guidelines on a realistic review of
expected future cash flow
2. Credit risk
 Transformation of risk should be taken into
account while devising a sound risk management
strategy
- For example, in Murabaha contracts, the risk
gets transformed from market risk to credit risk
- In Mudaraba and Musharaka contracts, equity
investment gets transformed to debt in case of
proven negligence for misconduct on part of the
Mudarib or Musharaka partners
 The role of promises must be scrutinized and
recognized in the complex structures
2. Credit risk
 Clearly define risk mitigating techniques including but
not limited to
- Methodology for setting Mark-up rates according to
the risk-rating of the counterparties
- Permissible and enforceable collaterals and
guarantees
- Clear documentation as to whether or not purchase
orders are cancelable
- Clear procedure for taking a/c of governing laws
Always try to buy the asset-to-be- financed on “sale-or-
return” basis
2. Credit risk
IBIs shall assess credit risk in a holistic
manner and ensure that credit risk
management forms a part of an integrated

For example, in a Salam contract, changes in

market risk factors such as commodity prices,
as well as the external environment (for
example, bad weather) become key
determinants affecting the likelihood of default.
2. Credit Risk
 The IBIs must have
 an appropriate credit strategy, including
pricing and tolerance for undertaking various
credit risks;
 a risk management structure with effective
oversight of credit risk management;
 credit policies and operational procedures
including credit criteria and credit review
processes, acceptable forms of risk
mitigation, and limit setting
2. Credit Risk
 an appropriate measurement and careful
analysis of exposures, including market- and
liquidity-sensitive exposures; and
 a system to
 monitor the condition of ongoing individual
credits to ensure the financings are made in
accordance with the IBIs policies and
procedures,
 manage problem credit situations according to
an established remedial process; and to
determine adequate provisions to be made for
such losses.
3. Equity investment risk
 Equity investment risk may be defined as the risk
arising from entering into a partnership for the purpose
of undertaking or participating in a particular financing
or general purpose activity as described in the contract,
and in which the bank shares in the business risk
- Market risk
- Liquidity risk
- Credit risk
- Other risks
 Capital impairment risk
3. Equity Investment Risk
 Principle 3.1: IBIs shall have in place
appropriate strategies, risk management
and reporting processes in respect of the
risk characteristics of equity
investments, including Mudārabah and
Mushārakah investments.
3. Equity Investment Risk
 Principle 3.2: IBIs shall ensure that their
valuation methodologies are appropriate
and consistent, and shall assess the
potential impacts of their methods on profit
calculations and allocations. The methods
shall be mutually agreed between the IBIs
and the Mudārib and/or Mushārakah
partners.
3. Equity Investment Risk
 Principle 3.3: IBIs shall define and
establish the exit strategies in respect of
their equity investment activities, including
extension and redemption conditions for
Mudārabah and Mushārakah investments,
subject to the approval of the institution’s
Sharī`ah Advisor.
3. Equity Investment Risk
 Risk mitigation
- Define and set the objectives of, and criteria for,
investment using profit sharing instruments
- Monitoring
 Evaluation of Sharia compliance, holding of
periodical meeting with partners and proper
recordkeeping of these meetings
 Monitoring of transformation of risks at various
stages of investment lifecycle
 Monitoring of factors affecting the expected
volume and timing of cash flows
3. Equity Investment Risk
 Valuation
 Appropriate valuation methods profit calculation and
allocation
 Assessment and measurement of potential
manipulation of reported results leading to
overstatements or understatements of partnership
earnings
 Independent audit and valuations
 Appropriate methods for the treatment of retained
profits
 Criteria for Exit strategies
4. Market Risk
 Principle 4.1: IBIs shall have in place an
appropriate framework for market risk
management (including reporting) in
respect of all assets held, including those
that do not have a ready market and/or are
exposed to high price volatility.
4. Market Risk
 The risk that arises from fluctuations in values of
tradable, marketable or leaseable assets
(including Sukuk) and in off- balance sheet
individual portfolios
 The risks relate to the current and future
volatility of market values of
- Salam based assets (due to commodity prices)
- Sukuk
- Murabaha assets( purchased to be delivered)
 Market risk exposures may occur at certain
times or throughout the contract
4. Market Risk
In operating Ijārah, a lessor is exposed to market risk on the
residual value of the leased asset at the term of the lease or if
the lessee terminates the lease earlier (by defaulting), during
the contract.
In Ijārah Muntahia Bittamleek, a lessor is exposed to market
risk on the carrying value of the leased asset (as collateral) in
the event that the lessee defaults on the lease obligations.
In Salam, IBIs are exposed to commodity price fluctuations
on a long position after entering into a contract and while
holding the subject matter until it is disposed of.
In the case of parallel Salam, there is also the risk that a
failure of delivery of the subject matter would leave the IBIs
exposed to commodity price risk as a result of the need to
purchase a similar asset in the spot market in order to honour
the parallel Salam contract.
4. Market Risk
 IBIs shall establish a sound and comprehensive
market risk management process and information
system, which (among others) comprise:
 a conceptual framework to assist in identifying
underlying market risks;
 guidelines governing risk taking activities in different
portfolios of depositors and their market risk limits;
 appropriate frameworks for pricing, valuation and
income recognition; and
 a strong MIS for controlling, monitoring and
reporting market risk exposure and performance to
appropriate levels of senior management.
4. Market Risk
 Market risk is closely related to other
forms of risks, and an overall measure of it
can be calculated with the help of an
appropriate VAR model
 Islamic banks then should ensure that
adequate capital is held against the
market risk
5. Liquidity Risk
 Principle 5.1: IBIs shall have in place a liquidity
management framework (including reporting) taking into
account separately and on an overall basis their liquidity
exposures in respect of each category of current
accounts, unrestricted and restricted investment
accounts.

 Principle 5.2: IBIs shall undertake liquidity risk

commensurate with their ability to have sufficient
recourse to Sharī`ah-compliant funds to mitigate such
risk.
5. Liquidity Risk
 Two major types of fund providers:
 current
account holders; and
 PLS Deposit holders
 PLS Deposit holders do not share in the
risks on assets financed by current
accounts, which are borne by shareholders
alone
 As fiduciary agents, the IBIs are concerned
with matching their investment policies with
PLS Deposit holders and shareholders’
risk appetites
5. Liquidity Risk
 Linked with displaced commercial and Shariah
compliance risks
 Islamic banks must maintain adequate liquidity
to meet their obligations at all times
- Strategy for managing liquidity involving effective
BOD and senior management oversight
- A framework for developing and implementing
sound processes for measuring and monitoring
liquidity
- Adequate systems in place for monitoring and
reporting liquidity exposures on a periodic basis
5. Liquidity Risk
- Adequate funding capacity, with particular
reference to the willingness and ability of
shareholders to provide additional capital
when necessary
- Liquidity crisis management, fixed asset
realization and sale and leaseback
arrangements etc.
5. Liquidity Risk
 Risk mitigation
- Diversity sources of funds
- Reduce concentration of funding base
- Rely on marketable assets
 Identity any future shortfalls in liquidity by
constructing maturity ladders
 Known cash flows
 Murabaha, Ijara, IMB and diminishing
Musharaka receivables
5. Liquidity Risk
 Conditional but predictable cash flows
 Salam and Istisna’ receivables

 Conditional and unpredictable cash flows

 Musharaka investments

 Periodic cash flow analysis under different scenarios

 A normal operating environment (e.g., a steady
state condition)
 Adverse circumstances (e.g., non-linear events
and chaotic conditions)
5. Liquidity Risk
 establish the maximum amounts of
cumulative liquidity mismatches they
consider acceptable
 Liquidation procedures must be
incorporated in the investment contracts
 Liquidity contingency plans addressing
various stages of liquidity crisis
6. Rate of Return Risk
 Principle 6.1: IBIs shall establish a comprehensive
risk management and reporting process to assess
the potential impacts of market factors affecting
rates of return on assets in comparison with the
expected rates of return for PLS Deposit holders.

 Principle 6.2: IBIs shall have in place an

appropriate framework for managing displaced
commercial risk, where applicable.
6. Rate of Return Risk
 An increase in benchmark rates may result in
PLS depositors having expectations of a higher
rate of return
 The actual return on assets may be under
performing as compared to the competitors’ rate
of returns
- Displace commercial risk
- Profit Equalization Reserve
- Investment Risk Reserve
7. Operational Risk
 Principle 7.1: IBIs shall have in place
adequate systems and controls,
including Sharī`ah Advisor, to ensure
compliance with Sharī`ah rules and
principles.
7. Operational Risk
 Principle 7.2: IBIs shall have in place
appropriate mechanisms to safeguard the
interests of all fund providers. Where PLS
deposit holders funds are commingled with
the IBIs own funds, the IBIs shall ensure that
the bases for asset, revenue, expense and
profit allocations are established, applied
and reported in a manner consistent with the
IBIs fiduciary responsibilities.
7. Operational Risk
 Shariah compliance risk
- The risk that arises form Islamic banks’ failure to
comply with the Shariah rules & principles
determined by the Shariah Advisor or the relevant
body in the jurisdiction in which Islamic banks
operate
 Fiduciary risks
- The risk that arises from the Islamic banks’ failure
to perform in accordance with explicit and implicit
standards applicable to their fiduciary responsibilities
7. Operational Risk
 IBIs shall establish and implement a clear and
formal policy for undertaking their different
and potentially conflicting roles in respect
of managing different types of investment
accounts.
 IBIs shall adequately disclose information

on a timely basis to their PLS deposit holders

and the markets in order to provide a reliable
basis for assessing their risk profiles and
investment performance.
ROLE OF SUPERVISORY
AUTHORITY
 adequate understanding on the wide array
of risks and satisfy itself that the IBIs have
in place an adequate risk management
and reporting process
 Develop and utilise prudential regulations
and requirements to control these risks
ROLE OF SUPERVISORY
AUTHORITY
 Credit Risk
 maintain a detailed description of each financing
instrument used by the IBIs in their jurisdiction and
the risk exposures to which each instrument gives rise
 may decide to develop Sharī`ah guidelines or
minimum documentations in respect of agreements
 adequacy of the policies and procedures to be
implemented by the IBIs to mitigate risks are subject
to review by the supervisory authority in compliance
with Sharī`ah
ROLE OF SUPERVISORY
AUTHORITY
 Equity Investment Risk
 satisfy itself that adequate policies and procedures
are in place for equity investment risk management
 ensure that the IBIs have sufficient capital when
engaging in equity investment activities
 may develop regulatory guidelines for measuring,
managing and reporting the risk exposures when
dealing with non-performance financing and providing
provisions
ROLE OF SUPERVISORY AUTHORITY
 Market Risk
 satisfy itself on the adequacy of IBIs internal
systems and controls and internal limits set by
the IBIs on their market risk management in
relation to the activities undertaken.
 Supervisory authorities should require IBIs in
their jurisdictions to develop guidelines for
acceptable valuation techniques where direct
market prices are not available, and should
approve such guidelines. Alternatively, the
supervisory authorities may themselves
develop such guidelines.
ROLE OF SUPERVISORY
AUTHORITY
 Liquidity Risk
 satisfy itself that the IBIs have adequate
liquidity policies, systems and controls in
place to manage their liquidity
 may establish appropriate minimum levels of
liquidity for each category
 central bank in its capacity as lender of last
resort may provide Sharī`ah compatible
mechanisms for liquidity arrangements to IBIs
as per stipulated regulations before the IBIs
can resort to seeking funds
ROLE OF SUPERVISORY
AUTHORITY
 Rate of Return Risk
 assess the capacity of the IBIs to manage the
rate of return risk may establish appropriate
minimum levels of liquidity for each category
 Where the supervisory authority may have a
policy of stating an expected rate of return for
unrestricted IAH, the supervisory authority
shall establish a framework within which this
is to be undertaken by the IBIs operating in its
jurisdiction
ROLE OF SUPERVISORY AUTHORITY
Rate of Return Risk
 The ROR framework may include amongst
others, methods, applicable periods and
recognisable income and expenses, and
other calculation bases relating to the use
of funds. This framework shall assist the
supervisory authority to assess the
efficiency of IBIs in terms of their
profitability and prudent management.
 ROLE OF SUPERVISORY AUTHORITY
 Operational Risk
 satisfyitself that IBIs have in place a
comprehensive and sound framework for
developing and implementing a prudent control
environment for the management of operational
risks
 IBIs have adequate Sharī`ah compliance
mechanisms in place
 well-defined and adequately qualified and staffed
organisational structure
 clear lines of authority and accountability

 policies and procedures for approval of products and

activities
ROLE OF SUPERVISORY
AUTHORITY
 Operational Risk
 prescribe formal guidance for the IBIs to ensure they
fulfil their fiduciary duties towards their IAH
 applicable auditing standards relevant to IBIs are
being implemented correctly in respect of the
assessment of the appropriateness of allocations,
distributions and reporting of profits to IAH
 The supervisory authority may require IBIs to have an
independent and regular review of Sharī`ah
compliance in this regard.
Risk Measurement
 Risk measurement methods
- Traditional
 GAP analysis
 Duration analysis
 Statistical analysis
 Scenario analysis
 Modern portfolio theory
 Variation from the mean
 VAR
 TEN RULES TO RISK MANAGEMENT

 There is no return without risks

 Rewards go to those who take risks
 Be transparent
 Risk should be fully understood
 Seek experience
 Riskis measured and managed by people, not by
mathematical models
 Know what you don’t know
 Question the assumptions made
 Communicate
 Risk should be discussed openly
 TEN RULES TO RISK MANAGEMENT
 Diversify-avoid concentration
 Multiple risks will produce more consistent rewards
 Show discipline
A consistent and rigorous approach will beat a
constantly changing strategy
 Use common sense
 Itis better to be approximately right, than to be
precisely wrong
 Return is only half of the equation
 Decisions should be made only after considering the
risks and returns of the possibilities
 Oversight must be enterprise-wide
 Risks cannot be managed in isolation
IFSB Capital Adequacy Standard
 Overview
 Largely based on the Basel approach, with necessary
modification and adaptation to cater for specific nature and
characteristics of Shariah compliant products and services
 Uses Risk weights derived from those proposed in Basel II
because of lack of historical data to modify risk weights
 For Credit Risk - Standardized approach
 Market Risk - 1996 Market Ris Amendment
 Operational Risk - Basic Indicator approach
 CAS is structured in a Matrix format to cater for transformation
of risk at different stages of contract
 Treatment of PSIA and assets financed by PSIA in CAR
 Adoption after Impact Study by SBP
 A Word of Caution

 Risk Management of your life is important

than everything.
 Would you ever think about it.
 Various risks are related with our body
and Soul. Some of them could harm a lot
and some less.
 Kindly Think about it .
For Comments and Suggestions please
contact:

Mahmood Shafqat
Senior Joint Director
Islamic Banking Department
State Bank of Pakistan
I.I. Chundrigar Road, Karachi
Ph: +92-21-9212509, 2453741
Fax: +92-21-9212472
E-mail: mahmood.shafqat@sbp.org.pk
 THANK YOU

MAY ALLAH THE ALMIGHTY SHOW US THE

RIGHT PATH,
THE PATH OF HIS LOVED ONES (AAMEEN)