PPT RISK MANAGEMENT IN ISLAMIC BANKING PowerPoint presentation
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RISK MANAGEMENT IN ISLAMIC BANKING
Title: Slide 1 Author: Mahmood Shafqat Last modified by: Mahmood Shafqat Created Date: 5/14/2005 11:34:48 AM Document presentation format: On-screen Show (4:3) PowerPoint PPT presentation
Title: RISK MANAGEMENT IN ISLAMIC BANKING
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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
RisksBasic 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 outcomesthis 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.
loss of earnings / capital or may result in
imposition of constraints on banks ability to
meet its business objectives.
RISK MANAGEMENT
- Risk Management involves identification,
measurement, monitoring, reporting and
controlling risks to ensure that
understand it.
limits established by Board of Directors.
business strategy and objectives set by BOD.
taken
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.
business lines
on organizations 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
9
- To put it simply and directly,
- if the bosses do not or cannot understand both
the risks and rewards in their products,
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)
(Legal risk, Documentation risk, etc)
RISKS FACED BY BANKS AND THEIR APPLICATION ON
ISLAMIC BANKING
ISLAMIC BANKING LESS RISKY?
- Islamic Banking is safer as it is not based on
INTEREST?
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
contract
prices and FX rates. Commodity risk in Murabaha,
Ijara, Salam
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.
return on investment. Also related to
fluctuations in returns due to changes in
underlying factors of the contract.
systems. Also includes Shariah non-compliance
Risk
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
BSD Circular No. 8 dt. Oct. 29, 2007
Circular No. 1 dt. Jan. 2, 2008.
dt. Oct. 27, 2005
No. 7 dt. May 27, 2004 and BSD Circular No. 1
dt. Jan.14, 2006
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 Shariah 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
1. General Requirement
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
strategies, policies and procedures
management structure
1. General Requirement
oversight
investment exposures
activities
direction and set clear lines of authority and
responsibility
risk taking activities
1. General Requirement
- Risk management process
- sound process for executing all elements of risk
measurement, mitigation, monitoring, reporting
and control
checks and balances
principles,
internal policies and procedures and
management processes
available to regulatory authorities
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
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
2. Credit Risk
- Principle 2.2 IBIs shall carry out a due
diligence review in respect of counterparties
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
Shariah-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
Salam contract with a third party
ability to repay
2. Credit risk
- The commodity price
- Dont use commodities with high price volatility
- A list of all types of applicable and approved
transaction and financing
systems and resources are available to implement
this strategy
capital tool
2. Credit risk
account while devising a sound risk management
strategy
transformed from market risk to credit risk
investment gets transformed to debt in case of
proven negligence for misconduct on part of the
Mudarib or Musharaka partners
recognized in the complex structures
2. Credit risk
- Clearly define risk mitigating techniques
including but not limited to
to the risk-rating of the counterparties
guarantees
orders are cancelable
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
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
- an appropriate measurement and careful analysis
of exposures, including market- and
liquidity-sensitive exposures and
credits to ensure the financings are made in
accordance with the IBIs policies and procedures,
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
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
Mudarabah and Musharakah 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
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 Mudarabah and
Musharakah investments, subject to the approval
of the institutions Shariah 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
stages of investment lifecycle
volume and timing of cash flows
3. Equity Investment Risk
- Valuation
- Appropriate valuation methods profit calculation
and allocation
manipulation of reported results leading to
overstatements or understatements of partnership
(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
volatility of market values of
or throughout the contract
4. Market Risk
- In operating Ijarah, 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.
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.
fluctuations on a long position after entering
into a contract and while holding the subject
matter until it is disposed of.
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
underlying market risks
different portfolios of depositors and their
market risk limits
4. Market Risk
risks, and an overall measure of it can be
calculated with the help of an appropriate VAR
model
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.
risk commensurate with their ability to have
sufficient recourse to Shariah-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
matching their investment policies with PLS
Deposit holders and shareholders risk appetites
5. Liquidity Risk
- Linked with displaced commercial and Shariah
compliance risks
meet their obligations at all times
effective BOD and senior management oversight
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
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
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
state condition)
and chaotic conditions)
5. Liquidity Risk
- establish the maximum amounts of cumulative
liquidity mismatches they consider acceptable
the investment contracts
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
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
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.
timely basis to their PLS deposit holders and the
markets in order to provide a reliable basis for
assessing their risk profiles and investment
ROLE OF SUPERVISORY AUTHORITY
and satisfy itself that the IBIs have in place an
adequate risk management and reporting process
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
minimum documentations in respect of agreements
implemented by the IBIs to mitigate risks are
subject to review by the supervisory authority in
ROLE OF SUPERVISORY AUTHORITY
procedures are in place for equity investment
risk management
engaging in equity investment activities
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
ROLE OF SUPERVISORY AUTHORITY
- Liquidity Risk
- satisfy itself that the IBIs have adequate
liquidity policies, systems and controls in place
to manage their liquidity
liquidity for each category
resort may provide Shariah 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
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
- satisfy itself that IBIs have in place a
comprehensive and sound framework for developing
and implementing a prudent control environment
for the management of operational risks
in place
organisational structure
and activities
ROLE OF SUPERVISORY AUTHORITY
- Operational Risk
- prescribe formal guidance for the IBIs to ensure
they fulfil their fiduciary duties towards their
IAH
are being implemented correctly in respect of the
assessment of the appropriateness of allocations,
distributions and reporting of profits to IAH
have an independent and regular review of
Shariah 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
- Risk is measured and managed by people, not by
mathematical models
TEN RULES TO RISK MANAGEMENT
- Diversify-avoid concentration
- Multiple risks will produce more consistent
rewards
constantly changing strategy
be precisely wrong
the risks and returns of the possibilities
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
Basel II because of lack of historical data to
modify risk weights
transformation of risk at different stages of
contract
CAR
A Word of Caution
- Risk Management of your life is important than
everything.
Some of them could harm a lot and some less.
