RISK MANAGEMENT IN ISLAMIC BANKING

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.

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, • 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

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

Credit Liquidity Credit Market Banking Risks Operational Solvency Legal/Regulatory Systemic Risk Dimensions Credit

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 andset 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 • quality and timeliness of risk reporting available to regulatory authorities • appropriate and timely disclosure of informationto 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 diligencereview 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.

RISK MANAGEMENT IN ISLAMIC BANKING