EXECUTIVE SUMMARY:RISK MITIGATION IN ISLAMIC FINANCE

INTRODUCTION This workshop aims to familiarize the participants with the main concepts of conventional and Islamic risk mitigation for financial institutions and spur ideas on how to proceed with a Shariáh compliant risk mitigation framework using Islamic products rather than replicate conventional risk mitigation techniques such as derivatives.

The objective of the workshop is to provide an analysis of conventional and Islamic risk mitigation in order to provide a clear understanding on how an Islamic bank should conduct its risk mitigation strategy.

INTRODUCTION I will provide a snapshot of risks in conventional and Islamic banking, conventional and Islamic risk mitigation techniques, reveal the Tense Dichotomy Between Shariáh Compliance and the Economic Goals of an Islamic Bank, explore Dispute Resolution and Financial Reporting as Risk Mitigation Techniques, explain Risks in the Sukuk Structure, and discuss Takaful as a Mitigation Technique, and the Risks Involved in Introducing Takaful into the United States.

The Sukuk and Takaful presentations have a USA angle as I believe this is an opportune time to enter the USA market with Islamic banking products.

OVERVIEW Risks in finance can be classified as business and financial risks.

Business risk is due to the uncertainty arising from the nature of a firm’s business.

It relates to factors affecting the product market. Financial risk is the uncertainty arising from possible losses in financial markets due to movement of financial variables.

It is usually associated with the risk that obligations and liabilities cannot be met with current assets.

RISK MANAGEMENT The implication of risk of outcomes can be assessed by examining the likelihood and impact of the risk.

The likelihood can be termed in probability terms. The impact can be measured as the total loss or value of assets lost.

In the case of subjective risks that cannot be quantified, the categorization of both likelihood and impact can be high, medium, or low.

RISK MANAGEMENT The goal of risk management is to take corrective actions to reduce the impact and likelihood that the residual risks can be brought within the tolerable loss range.

The impact can be reduced by controlling the sources from which they arise and instituting limits to the exposures.

For example, credit risk can be reduced by controlling the exposure to such risk by exercising due diligence to reduce the probability of default.

RISK MANAGEMENT Risk entails both vulnerability and opportunities. There are various costs associated with higher risk (volatility) of cash flows.

These include higher expected bankruptcy costs, higher expected costs to corporate stakeholders, and higher expected tax payments.

Successful firms are not those that reduce risks, but those that take advantage of the opportunities offered by risk-taking.

RISK MANAGEMENT The objectives of risk management are first and foremost to reduce the volatility of cash income, cash flows, a firm’s market value, return on equity, and cost of borrowing.

From the stakeholder’s perspective, managing risks would involve firm value maximization, elimination of costly lower tail outcomes, and maintaining a certain financial risk profile.

RISK MANAGEMENT Risk management refers to the overall process that a financial institution follows to define a business strategy, to identify the risks to which it is exposed, to quantify those risks, and to understand and control the nature of risks it faces.

While risk reduction is defensive and is used to protect firms from risk by using hedging, insurance and derivatives, risk management is about using the risk to an organization’s advantage by seeking it out to exploit uncertainty and risks through various proactive policies to create value.

Risk management is strategic and should be part of the corporate strategy.

RISK MANAGEMENT Risks facing financial institutions can be of three types: Risks that can be eliminated, risks that be transferred to others, and risks that can be managed to the institutions themselves.

The practice of the financial institution is to take up activities in which the risks can be effectively managed and to shift the risks that can be transferred.

RISK MANAGEMENT Risk avoidance techniques would include the standardization of all business-related activities and processes, construction of a diversified portfolio, and implementation of an incentive-compatible scheme with accountability of actions.

Some risks facing banks can be reduced or eliminated by transferring or selling these in well-defined markets.

Risk transferring techniques include, among others, use of derivatives for hedging, selling or buying of financial claims, changing borrowing terms, etc.

RISK MANAGEMENT There are some risks that cannot be either eliminated or transferred and must be absorbed by the banks.

These risks are accepted by the financial institutions as they are central to their business and the banks are specialized in dealing with them.

Once a bank decides that it has a comparative advantage in taking certain risks, it has to determine the role of its risk management in exploiting this advantage.

RISK MANAGEMENT Note that a firm’s ability to undertaking activities involving risk not only depends on its risk management policy, but also on its capital structure and general financial health.

Risk management and capital are in some ways substitutes for each other in the protection against risks in financial exposures.

Hence, when firms lower their risks through efficient risk management, the capital requirement is also reduced.

ISLAMIC RISK MANAGEMENT From an Islamic perspective, economic activities are not judged by their inherent risks, but by whether they add value and/or create wealth.

Hassan (2009) identifies three types of risks from the Islamic perspective.

First is the essential risk that is inherent in all business transactions. This business risk is necessary and must be undertaken to reap the associated reward or profit.

HASSAN ON ISLAMIC RISK MANAGEMENT Two legal maxims associating returns to essential risks form the basis of Islamic economic transactions.

The first maxim states, “the detriment is as a return from the benefit (al ghurm bil ghunm) (Majalla Art. 87). This maxim attaches the entitlement of gain to the responsibility of loss. This maxim is usually used to propose the preference for profit-and-loss (PLS) financing instruments.

The second maxim is derived from the Prophetic saying, “al kharaj bil daman” stating “the benefit of a thing is a return for the liability for loss from that thing” (Majalla Art. 85). The maxim asserts that the party enjoying the full benefit of an asset or object should bear the risks of ownership.

HASSAN ON ISLAMIC RISK MANAGEMENT The second prohibited risk is in the form of excessive gharar.

The third form of risk is the permissible risk that does not fall in the above two categories i.e. operational and liquidity risk. These risks can be either accepted or avoided.

AL-SUWAILEM ON ISLAMIC RISK MANAGEMENT Al-Suwailem links risk with causality. He asserts that there is a need to distinguish between causes and uncertain outcomes.

In uncertain situations, individuals have control over the causal factors, but not the outcome.

Citing the Prophetic saying of “tie the camel and then entrust it to God,” he asserts that the Islamic approach to risk management would be to understand and control the causes of risks and then leave the final outcome to the will of God.

AL-SUWAILEM ON ISLAMIC RISK MANAGEMENT Al-Suwailem also discusses the ethics of risk management in Islam.

He asserts deeds are judged according to intentions and means are treated in the same manner as ends.

Thus, if an action can lead to various outcomes, its value should be judged by the most probable outcomes.

An economic activity creating value would be one in which the probability of gain would exceed the probability of loss.

However, an individual’s attitude towards risk is not subject to rigid rules.

AL-SUWAILEM ON ISLAMIC RISK MANAGEMENT While some individuals may have the inclination to take more risks than others, engaging in gambling like activities is discouraged.

This includes activities where the probability of success is less than the probability of failure or loss.

GOALS OF RISK MANAGEMENT As the objective of financial institutions is to create value for shareholders, managing the resulting risks created to achieve this becomes an important function of these institutions.

The returns need to be positive to compensate the investor for the time the funds are committed, the expected rate of inflation, and the uncertainty of future payments or risk.

RISKS FACED BY FINANCIAL INSTITUTIONS The balance sheet of a financial institution gives us an indication of the nature of risks that the institution faces.

A typical balance sheet of a bank will have the equity and deposits/debt on the liabilities side and the banking and trading portfolios on the asset side.

Schroeck (2002) divides risks faced by IFI’s into two types. First, risks related to the balance sheet or both assets and liabilities. These risks include interest rate, exchange rate, and liquidity. Second, there are transaction risks that relate to the assets side of the balance sheet only. These risks are credit, market, and operational.

RISKS FACED BY ISLAMIC FINANCIAL INSTITUTIONS To understand the risks faced by Islamic banks, it is important to examine their balance sheet.

Iqbal et.al. (1998) distinguished two models of Islamic banks based on the structure of their assets.

The first is the two-tier mudarabah model that replaced interest by profit-sharing modes on both liability and asset sides of the bank.

In particular, all assets in this model are financed by profit-sharing modes of financing (mudarabah). This model of Islamic banking will also act as an investment intermediary, rather than only a commercial bank.

RISKS FACED BY ISLAMIC FINANCIAL INSTITUTIONS The second model of Islamic banking is the one tier mudarabah with multiple investment tools.

RISKS FACED BY ISLAMIC FINANCIAL INSTITUTIONS On the assets side, Islamic banks use murabahah, instalment sale (medium/long-term murabahah), bai-muajjal (price-deferred sale), istisnaá/salam (object deferred sale or pre-paid sale), ijarah (leasing), and profit-sharing modes of financing (musharakah and mudarabah).

On the liabilities side of the balance sheet of Islamic banks, savings and investment deposits take the form of profit-sharing investment accounts (PSIAs).

RISKS FACED BY ISLAMIC FINANCIAL INSTITUTIONS Demand deposits or checking/current accounts in Islamic banks take the nature of qard hasan that are returned fully on demand.

Using the profit-sharing principle to reward depositors is a unique feature of Islamic banks.

The returns on PSIAs are state-contingent and neither the principal nor a return is guaranteed.

The owners of the PSIAs participate in the risks and share in the bank’s profit and losses.

RISKS FACED BY ISLAMIC FINANCIAL INSTITUTIONS Investment Accounts can be further classified as restricted and unrestricted (PSIA).

In the former, the bank can use the fund only in specific assets , while in the latter, the bank has the freedom to use the funds as it deems best.

This feature, along with financing instruments, changes the nature of risks that Islamic banks face.

RISKS IN ISLAMIC MODES OF FINANCING As Islamic financial instruments are either asset-backed or equity-based, market risks become important along with credit risks.

Transactions may involve transfer of cash or assets/goods that the IFI owns either on the spot or at a future time.

As the IFI is engaged in financing and investment, its ultimate goal is to finance trade or invest in assets or equity to earn a return.

Thus, the objective of the IFI is to liquidate the financing or investments at the end of the contract period and not hold on to the assets or goods forever.

RISKS IN ISLAMIC MODES OF FINANCING When the IFI has cash in the current time period, there are no risks involved.

If the IFI holds assets of goods on the spot, it needs to dispose of them.

In doing so, it is subject to market risk as the price of the assets or good may change.

When an IFI is expecting cash from a transaction at the future date, it faces credit risk as the debtor may not pay what is due on time.

RISKS IN ISLAMIC MODES OF FINANCING Similarly, if an asset or good is due at a future date, market risk rises along with credit risk, as the price of the asset may change during that time.

THE FIRST PRINCIPLE OF IFSB (2005A:4) The IFI 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 and, where appropriate, to hold adequate capital against these risks.

The process shall take into account appropriate steps to comply with Sharia’h rules and principles and to ensure the adequacy of relevant risk reporting to the supervisory authority.

RISK MANAGEMENT SYSTEM A comprehensive risk management system should encompass the following three components:

1. Establishing Appropriate Risk Management System and Environment

2. Maintaining an Appropriate Risk Measurement System 3. Adequate Internal Controls

ESTABLISHING APPROPRIATE RISK MANAGEMENT SYSTEM Senior management is responsible to implement the policies approved by the Board through the establishment of a risk management system.

The Management needs to establish policies that would be used by the institution to manage risks.

These include developing a risk management review process, setting appropriate limits on risk-taking, developing adequate systems of risk measurement, ensuring a comprehensive reporting system, and maintaining effective internal controls.

ESTABLISHING APPROPRIATE RISK MANAGEMENT SYSTEM Procedures should include appropriate approval processes, limits, and mechanisms designed to assure the bank’s risk management objectives are achieved.

Banks should clearly identify the individuals and committees responsible for risk management and define the line of authority and responsibility.

MAINTAINING AN APPROPRIATE RISK MEASUREMENT SYSTEM There are four ways in which the risk management system can be operationalized.

They are standards and reports, position limits and rules, investment guidelines or strategies, and incentive contracts and compensation.

In setting the standards, the management identifies and categorizes the risks and spells out the tools to control and manage these risks.

To assist in identifying these risks, there is a need for standardized financial reporting that provides information on various aspects of a risk, risk exposures, and asset quality in terms of inherent risk.

MAINTAINING AN APPROPRIATE RISK MEASUREMENT SYSTEM The second aspect of the risk management system is to have position limits and rules that indicate the level of risk undertaking.

Clear rules and standards of risk undertaking regarding eligible features for investments, limits of exposures to counter-parties, concentration limits, exposure to various types of risks etc. should be provided.

MAINTAINING AN APPROPRIATE RISK MEASUREMENT SYSTEM The third element of a risk management system consists of investment guidelines and strategies, the former for operational reasons, and the latter for long-term directions.

Investment guidelines and strategies should be followed to limit the risks involved in different activities.

These guidelines should cover the structure of assets in terms of concentration and maturity, asset-liability mismatching, hedging, securitization and so on.

MAINTAINING AN APPROPRIATE RISK MEASUREMENT SYSTEM Banks must have adequate management information systems (MIS) for measuring, monitoring, controlling, and reporting different risk exposures on a periodic basis.

Steps that need to be taken for risk management and monitoring purposes include the establishment of standards for categorization and review of risks, consistent evaluation, and rating of exposures.

Periodic standardized risk and audit reports within the institution are also important.

The bank can also use external sources to assess risk, such as using either credit ratings or supervisory risk assessment criterion.

MAINTAINING AN APPROPRIATE RISK MEASUREMENT SYSTEM Banks should consider doing stress tests to see the effects on the portfolio resulting from different plausible events.

Stress testing should be designed to identify the conditions under which a bank’s positions would be vulnerable and the possible responses to such situations.

The banks should have contingency plans that can be implemented under different scenarios.

ADEQUATE INTERNAL CONTROLS Banks should have internal controls to ensure the adherence of all relevant policies.

An effective system of internal control includes an adequate process for identifying and evaluating different risks and having sufficient information systems to measure and report them.

The system would also establish policies and procedures and make sure that adherence to them is continually reviewed.

This may include conducting periodic internal audits of different processes and producing regular independent reports and evaluations to identify areas of weakness.

ADEQUATE INTERNAL CONTROLS Finally, an appropriate incentive and accountability structure that is compatible with risk-taking activity forms part of the important elements for reducing overall risks.

The incentives given to different risk undertakers should reflect the objectives and the goals of the institutions.

A pre-requisite of these incentive-based contracts is accurate reporting of the bank’s exposures and its internal control system.

An efficient incentive-compatible structure would limit individual positions to acceptable levels and encourage decision-makers to manage risks in a manner that is consistent with the bank’s goals and objectives.

INFRASTRUCTURE AND RISKS As Islamic Banking is relatively new and lacks an adequate regulatory or legal framework, this gives rise to risks at the macro-level such as systemic risk, liquidity risk, Shari’ah- compliance risk, reputation risk, legal, and regulatory risk.

I recommend the Dubai World Islamic Finance Arbitration Center (DWIFAC) and Jurisprudence Office (DWIFACJO) as well as a centralized regulatory authority for the industry.

LIQUIDITY RISK There is a fiqh restriction on the securitization of the existing assets of Islamic Banks, which are predominantly debt in nature.

Due to the slow development of innovative financial instruments, Islamic banks are not able to raise funds from the markets very quickly.

There is a dearth of short-term Shariáh compliant securities or markets for liquidity risk management.

This is mainly limited to Shariáh compliant interbank money markets. Also, generally, the existing liquidity risk facilities are based on interest and therefore, Islamic banks cannot benefit from these facilities.

SHARIA’H NON-COMPLIANCE AND REPUTATION RISKS Negative perceptions of stakeholders about Islamic products and practices can lead to instability in the short-term and cause loss of trust and credibility in the long-run.

The possibility of the SSB’s coming up with conflicting opinions within one jurisdiction can increase the legal risks.

Conflicting fatwas can undermine customer confidence in the industry.

I recommend a centralized Shariáh Supervisory Board to oversee opinions and fatwas and regulate Shariáh scholars.

LACK OF STANDARDIZED CONTRACTS

Lack of standardized contracts at the national and international levels makes the process of negotiation contracts costly.

I recommend the DWIFAC Jurisprudence Office to issue standardized contracts for the industry.

As a result, IFIs are not protected against risks that they cannot anticipate or may not be enforceable in courts.

Standardized contracts are easier to administer and monitor after the contract is signed.

It is very risky to conduct Islamic financial business without a formal and unique dispute settlement mechanism for the industry.

ORGANIZATIONAL LEVEL RISKS At the organizational level, the techniques of risk identification and management available to Islamic banks could be of two types.

The first type comprises standard techniques that are used in conventional finance and are consistent with the Islamic principles of finance.

These include risk reporting, internal and external audit, GAP analysis, Risk Adjusted Return on Capital (RAROC), internal ratings, etc.

The second type of technique is unique to IFIs and has to be developed or adapted to satisfy Shariáh-compliance requirements.

This requires understanding the risks, principles, and values of Islamic Law (Shariáh).

OPERATIONAL RISK One of the challenges facing IFIs is the lack of qualified professionals (capacity and capability) who can understand and manage risks in Islamic financial operations.

Given the uniqueness of Islamic banking, the computer software available in the market for conventional banks may not be appropriate for Islamic banks.

Furthermore, the MIS systems that can measure and monitor risks are very costly.

This gives rise to system risks of developing and using informational technologies at Islamic banks.

ORGANIZATIONAL LEVEL RISKS It is important to have accurate data for a good approximation of the distribution of returns on various assets.

Once the loss distribution has been identified, than an estimation of sufficient capital can be set aside to absorb losses.

Secondly, economic capital is held to provide comprehensive coverage of losses for the institution as a whole and is an important tool for integrated risk management.

The amount of capital held by any bank will depend on the risks associated with the assets.

ORGANIZATIONAL LEVEL RISKS Given the profit-sharing nature of PSIA’s in Islamic Banks, there are suggestions that the PSIA may be treated as capital. There is, however, a need for caution in treating all PSIAs as capital. Fund providers in PSIAs are risk averse and too much downside in their returns can lead to withdrawals that can create systemic risks.

Thus, to minimize the withdrawal and systemic risk, none or only a very small portion of PSIAs should be treated as capital.

When assets are funded by PSIAs, however, a larger part of the funds can be treated as capital.

ORGANIZATIONAL LEVEL RISKS The IFI may be able to estimate the risk distribution accurately, but fail to take the necessary steps to mitigate and transfer them using various means and processes.

I.E. IFIs should hold sufficient loan loss reserves to protect against expected credit losses.

The effectiveness of these reserves depends on the credibility of the systems in place within banks to calculate the expected losses.

ORGANIZATIONAL LEVEL RISKS Recent developments in credit risk management techniques have enabled large traditional banks to identify their expected losses accurately.

Islamic banks are also required to maintain the mandatory loan loss reserves subject to the regulatory requirements in different jurisdictions.

ORGANIZATIONAL LEVEL RISKS The Islamic modes of finance are diverse as compared to interest-based credit and therefore requires a more rigorous and credible system for expected loss calculation.

There is also a need for uniform standards of loss recognition across modes of finance, Islamic banks, and their regulatory jurisdictions.

In addition to mandatory reserves, some Islamic banks have established PER (Profit Equalization Reserve) and IRR (Investment Risk Reserve).

These reserves provide protection for capital as well as PSIA against risk of loss (including default) and to minimize the withdrawal risk.

The profit equalization reserve (PER) is the amount appropriated by an Islamic bank or financial institution out of the mudaraba income before allocating the share of al-mudarib. This reserve aims to maintain a specified level of return on investment (ROI) for investment account holders (IAHs). In other words, it represents a measure of profit stabilization over different financial periods. The PER is also formed for the purpose of increasing owners’ equity.

The investment risk reserve (IRR) refers to the amount appropriated by an Islamic bank or financial institution out of the income of investment account holders (IAHs), after the mudarib share is allocated. This reserve is used as a cushion against future losses that IAHs may incur.

PER V. IRRPER

Mudarabah Income

Before Mudarib Share is Allocated

Profit Stabilization/Smoothing

IAHs and al-Mudarib

IRR

IAH

After Mudarib Share is Allocated

Cushion Against Future Losses

IAHs

INSTRUMENTS AND TECHNIQUES Risk Management can involve avoidance, transfer, or acceptance of risks.

Risk avoidance techniques in IFIs include the standardization of all business-related activities and processes, construction of a diversified portfolio, and implementation of an incentive-compatible scheme with accountability of actions.

The guiding principle of risk management and mitigation at the instruments level from an Islamic perspective should be to improve asset quality with the focus on risk-sharing.

INSTRUMENTS AND TECHNIQUES Possibilities of shifting risks to other participants creates incentive to take on higher risks.

Using equity modes of financing may induce stringent due diligence and monitoring of assets by financial institutions, which can prevent systemic risks arising from transferring risks.

CONCLUSION It is important to see a Shariáh compliant risk mitigation framework emerge for the Islamic Banking Industry rather than one based on reverse engineered conventional products.

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