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Risk characteristics of Islamic
financial products
Institute of Islamic Banking & Insurance
London 15th December 2004
Warren Edwardes
Risk characteristics of Islamic financial products
� Institute of Islamic Banking & Insurance
� London 15th December 2004
� Warren Edwardes,
� ceo, Delphi Risk Management Limited
� email: [email protected]
� web: dc3.co.uk
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Delphis website contains:
� articles on Islamic banking on:dc3.co.uk/islamicbanking
� This PowerPoint is on:dc3.co.uk/islamicfinancerisk041215.ppt
� with notes on dc3.co.uk/islamicfinancerisk041215.pdf
� Speech drawn from the book "Key Financial Instruments"
� Appendix 1 (50 Risk types)
± dc3.co.uk/risks.htm
� Appendix 4 (Islamic banking)± dc3.co.uk/islamicbanking.htm
Warren Edwardes
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financial risk
� some actions can protect
� the same actions can destroy
� risk a film
Warren Edwardes
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Warren Edwardes
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� Does Islamic banking risk differ from Conventional banking risk?
� Not different - just a very special case±
Trade credit ? ± Asset backed Secured or unsecured ?
± Debt or equity ?
± Leasing ?
± Repos / Murabaha ?
± Fund management ? � Islamic Banking is ALL about who bears risk
Warren Edwardes
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A check-list of 50 banking risk types
� To put it simply and directly,
� if the 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
Warren Edwardes
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banking risk types - 1-4
� Acquisition Risk
± Different cultures between banks consolidating
� Careless Error Risk
± Human error should be forgiven. But this is not covered by
law
� Competitive Risk
± LIBOR determines competitors returns
� Commodity Risk
± If you take delivery can the commodity price be managed?
Warren Edwardes
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banking risk types - 5-8
� Communication Risk± Define terms clearly
± Deposit or managed funds?
�
Country Risk± much of Islamic banking is carried out in emerging
markets. Riskier? Pakistan is stable in the eyes of Mid Eastinvestors
� Credit Risk±
Not loans. Not IOUs. So equity not loan risk� Cultural Risk
± Difference between Gulf and Malaysia - narrowing
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banking risk types 9-12
� Currency Transaction Risk
± use of derivatives generally not allowed? Cannot hedgeexchange rate for purchases
�
Currency Translation Risk± Balance sheet value of dollar assets or liabilities fluctuate
� Currency Economic Risk
± Again no hedging permitted. So can Malaysia compete
with USD based countries when the USD depreciates?� Customer Satisfaction Risk
± If a bank pays no dividends customers will get angry
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banking risk types - 13-16
� Disaster Recovery Risk
± If a terrorist or earthquake strikes can you cope?
� Economic Activity Risk
± Applies when overheads are fixed. Outsourcing a solution
� Energy Price Risk
± Many Islamic countries economies are linked to the oil
price
� Environment Risk
± Are environment unfriendly policies haram?
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banking risk types - 17-20
� Equity Market Risk± Islamic banking is ideally profit and loss sharing. This is
venture capital or equity investment
� Fraud (banker) Risk± Transparency is required. Avoid the risk of
misinterpretation and mis-selling
� Fraud (customer) Risk± If an investor loses money will he seek redress? Of course
if he wins he will not� Fraud (staff) Risk
± Haram for lenders to seek material benefit. BCCI was notan Islamic bank but fraud could occur in Islamic banks
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banking risk types - 21-24
� Image / PR Risk± Something hallal could be deemed haram. Sep 11 was bad
PR for Islamic banks
� Information Risk± Lack of transparency in accounts in many Islamic countries
� Inflation Risk± Securitised asset rises in value but not the repayment
amount which being a cash amount depreciates. Time
value of money?� Interest rate Risk
± This is not a closed economy. If interest rates rise sharplydeposits will flow out. LIBOR linking
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banking risk types - 25-27
� Interaction Risk
± Correlation risk. What happened in New York andBaghdad impacts on KL. Gold standard?
� Language Risk
± Arabic, English, Malay, Indonesian, Urdu? Same wordcan have different meanings.
� Legal Risk± UK, Malaysian, .. Is the bank / customer permitted to
carry out such business?. Ultra Vires issue
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banking risk types - 28-30
� Liquidity Risk± Major problem for Islamic banking is the absence of a
developed Islamic money market.
±
about managing confidence and the liability side± About managing diversification.
� Morbidity Risk± No different from conventional banking. What happens if there
is an outbreak of dengue fever or Anthrax?
� Mortality Risk± Do you have offices in a tall building?
± Would you survive major loss through fire?
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banking risk types - 31-34
� Operational Risk
± Are strong procedural systems in place? Really everythingother than market risks
�
Performance Measurement Risk± Most measures of performance are crude and slavish
adherence to rules can lead to poor real performance
� Political Risk
±
Seizure of assets post Sep 11; boycotts by Western banks� Competence / Understanding
± Are the latest products really understood by the bankssenior management? By the customers?
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banking risk types - 35-38
� Concentration of assets Risk
± A problem for Islamic funds. No tobacco, banking and alcoholstocks can lead to heavy weighting in property and technology
� Concentration of liabilities Risk
± Do you have enough investors or do you depend on one or two?
� Concentration of business type Risk
± Financial supermarket or nimble niche player are both fine. Butcan you reinvent yourself if markets change?
± Can you cope with the entry of HSBC / Barclays / Citibank?� Convertibility Risk
± Deliverability risk under exchange controls
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banking risk types - 39-42
� Property (Real Estate) Risk
± Would asset backing be sufficient in times of a property crash?
� Rating Agency Risk
± Adowngrading or even credit watch can impact on liquidity andthe entire business. Investment grade bonds do not default.
They become junk and then default.
� Regulatory Risk
± A firm operating globally will face different rules
� Religious Risk± A Hallal product may later be deemed Haram. Zero coupon
bonds were once Hallal. Other than Malaysia no Central Shariahauthority
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banking risk types - 43-46
� Resignation Risk± Over dependence on one persons skills and market
contacts?
� Settlement Risk± If there is no escrow account there is settlement risk on
Murabaha and BBA
� Systemic Risk± Financial instability is contagious. Financial systems
are closely inter-linked� Tax Risk
± Do the sale and repurchase transactions face VAT? Incometax or capital gains tax treatment?
Warren Edwardes
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banking risk types 47-49
� Technological Risk± Are your fax confirmations going to your customer or a
competitor?
� Transport Risk± traffic jams may have led to cancelled meetings which may
never be rearranged
� Weather Risk± Could you hedge against the weather? KLs 1998 smog and
Kuwaits burning oil fields probably had an adverse impacton employees health.
± Weather derivatives are being traded. Haram? WeatherTakaful?
Warren Edwardes
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banking risk types 50
� Zero Risk
� Its impossible to take an unnecessary risk.
� because you only find out whether a risk wasunnecessary
� after youve taken it
� Giovanni Agnelli, President F IAT
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Particular Islamic banking risk issues
� Liquidity under developed money market
� Interest rate Risk
� Commodity Risk
� Communication Risk
� Equity risk fund management or banking?
� Operational risk
� Religious Hallal or Haram?
� Language Risk - English, Arabic, Malay or Urdu
Warren Edwardes
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Risk Issues In Islamic Banking
Warren Edwardes