Risk Management in Islamic

Financial Institutions

Rifki Ismal

APRACA International Course on

Islamic Banking and Finance

Jakarta, 30 October 2012

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Associate Professor Rifki Ismal

• Education and Title

– Bachelor degree in economics, University of Indonesia.

– Master in Applied Economics, Department of Economics, University of Michigan, Ann Arbor (USA).

– PhD in Islamic Finance, Durham University (England)

– Associate Professor, Australian Center for Islamic Finance

• Education

– Assistant Director at Department of Islamic Banking, BANK INDONESIA (Central Bank of Indonesia).

– Lecturer at University of Indonesia.

– Lecturer at Trisakti University, Indonesia

– Lecturer at Paramadina University, Indonesia

– Lecturer at Strasbourg University (France) (2009)

CURRICULUM VITAE

Islamic Finance and Risk

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Core Values

All principles of Sharia should be part of man’s obedience and worshiping God.

Every Sharia contract should aim to improve the welfare of people and societies.

Businessmen have to have trust, support each other and, sharing risks

Prohibition of Riba, gharar, maysir, zulm, haram and unfair business transaction.

Final target is falah, reflected in the implementation of Maqasid al sharia

Referring to Islamic law: Qur’an, Hadist, Ijtihad, Ijma, Qiyas, Urf, Istishsan, Istislah,

etc

Honouring property right, individual and social obligation, work and self interest, etc.

Encouraging working hard, blessed wealth, healthy competition.

The ultimate owner of all property is God, human is only His vicegerent.

Obligation to pay zakah, and highly suggested to pay shadaqoh, waqf, hadiah, infaq,

etc

FUNDAMENTAL THEORY OF ISLAMIC FINANCE

Islamic Finance Contracts (Sharia Based) Non Islamic Arabic Contracts

Mudarabah Riba Jahiliah

Musharakah Riba al Fadhl

Murabahah Riba an Nasyiah

Salam Talaqi ruqban

Istishna Ikhtikar

Ijarah Bay kali bi kali

Musaqah Bay Najasi

Muzaraah Gharar

Sukuk Qimar, Maysir

Wadiah, Kafalah, Hiwalah Zulm

CLASSIC ISLAMIC FINANCE CONTRACTS

RISK MANAGEMENT IN FINANCIAL INSTITUTIONS

• Risk management determines the successfulness of financial institutions in managing funds and providing well-expected return to stakeholders.

• It prevents a bank from financial failure, insolvency, liquidity distress, etc and build a good communication/coordination with stakeholders.

• It measures and explains every type of risk which will allow a bank to take necessary actions to anticipate and mitigate any risk.

RISK MANAGEMENT IN FINANCIAL INSTITUTIONS

• In general it is necessity for the robustness of the overall financial system and economic stability at the end.

• Risk management unexceptionally becomes part of Islamic banking institutionwith its unique characteristics and operations.

• Risk in financial terms is usually defined as the probability that the actual return may differ from the expected return (Howells and Bain, 1999:30). There are in fact three broad categories of risk namely (1) Financial risk, (2) Business risk and lastly (3) Operational risk.

TYPES OF RISKS IN BANKING

Credit Risk Management Risk People Risk

Default Risk Planning Risk Relationship Risk

Down Grade Risk Organization Risk Ethics Risk

Counter party Risk Reporting Risk Processes Risk

Settlement Risk Monitoring Risk

Legal Risk

Market Risk Strategic Risk Compliance Risk

Commodity Price Risk R & D Risk Control Risk

Equity Price Risk Product Design Risk

Interest Rate Risk Market Dynamic Risk System Risk

Exchange Rate Risk Economic Risk Hardware Risk

Reputation Risk Software Risk

Liquidity Risk Models ICT Risk

Asset-Liability Imbalance

Maturity Mismatch Risk Followed by External Risk

Insolvency Risk Event Risk

Gov't Taken Over Risk Client Risk

Reputation Risk Security Risk

Legal Risk Supervisory Risk

System Risk

Source : Tariqullah Khan, 2006 (modified) Equity Investment Risk

FINANCIAL AND

BUSINESS RISK

Financial Risk Business Risk Operational Risk

• Risk can be expressed within a casual and interactive system, as the impact of each risk can’t be seen isolated, since they correlate and influence each other.

• Financial risk is the exposures that result in a direct financial loss to the assets or liabilities of a bank. Besides credit, market risk and liquidity risk, Islamic banks face equity investment risk.

• Credit risk relates to the performance of entrepreneurs: failure to fulfill their payment obligations, settlement, clearing, etc.

TYPES OF RISKS IN BANKING

• Market risk happens due to

unfavorable price movement or

economic/financial condition such as

RoR risk, exchange rate, inflation, etc.

Unlike conventional one, Islamic banks

bear risk of tradable, marketable,

leaseable asset and mark up risk.

• Liquidity risk consists of 2 part: (i)

Liquidity of financial instruments in

financial market and; (ii) Liquidity

related to solvency.

TYPES OF RISKS IN BANKING

• Business risk links with the performance of bank’s business and

internal action such as business

policy, infrastructure, payment

system, etc.

• Thus business risk deals with (i)

management risk which asks how is bank’s planning, organizing,

monitoring, reporting, etc and (ii)

strategic risk is like R&D, product

design, etc.

TYPES OF RISKS IN BANKING

• Operational risk occurs if a bank fails to

manage people, system, legal, external risk

and equity investment. It is internal process

risk which brings together harmonization of :

– People (relationship, ethics, process, etc);

– Legal (compliance and control risk);

– System (hardware, software, etc) and;

– External risk (event, clients, security,

supervisory, etc).

– Equity investment (asset, pricing,

valuation).

TYPES OF RISKS IN BANKING

• Mark up risk is risk because of

fluctuation of benchmark rate or

inaccurate/unfavorable mark up

determination.

• Commodity price risk happens due to

the fluctuation of price of a

commodity.

• Legal risk is because of improper

regulation, lack of regulation, etc.

TYPES OF RISKS IN BANKING

• Withdrawal risk is when depositors

take out their money for regular or

irregular reasons.

• Fiduciary risk, when Islamic bank

operates unislamically (violating

sharia principles).

• Displaced commercial risk occurs

when depositors switch their deposit

into conventional one which offers

more profitable/attractive return.

TYPES OF RISKS IN BANKING

Islamic Banking Principles and

Internal/External Factors

Leading to Risks

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• Islamic contracts require depositors to fully understand consequence of dealing with Islamic bank particularly: no guarantee/fixed return on deposit, no return on demand deposit, periodical withdrawal on long term time deposit and risk/return sharing.

• Islamic bank mitigates its risk through risk sharing with depositors and entrepreneurs particularly profit and loss sharing (PLS) or return sharing scheme.

ISLAMIC BANKING PRINCIPLES & RISK MANAGEMENT

• Economic / financial market risks are pure risk that can not be hindered by all parties but have to be minimized, avoided and handled properly. Islamic bank does not eliminate risk (interest based) but sharing/handling risk.

• Regulator coordinates and designs proper legal and regulatory standard to control and manage performance of Islamic banking as well as preventing any unfavorable economic/business condition.

ISLAMIC BANKING PRINCIPLES & RISK MANAGEMENT

INTERNAL/EXTERNAL FACTORS & RISK MANAGEMENT

PROBLEMS IN HANDLING RISK IN ISLAMIC BANKS

• Every Sharia contract

connects/relates with performance

of real sector. Interest rate

disconnects financial sector with real

sector.

• Market risk applies directly or

indirectly in every Islamic contract.

PROBLEMS IN HANDLING RISK IN ISLAMIC BANKS

• Due to its early stage of development, Islamic banking industry faces lack of infrastructure, technology, regulation, lack of eligible human resources, lack of product innovation, etc. All of them might invite risk into the operation of Islamic bank.

• Islamic banks are free from interest rate risk but indirectly impacted by it.

Risk in Sharia Jurisprudence and

Sharia Mechanism in Risk

Management

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RISK IN SHARIA JURISPRUDENCE

• Risk is close to definition of gharar in sharia.

• Gharar is any uncertainty or ambiguity created by the lack of information or control in contract.

• By size, there are gharar fahish (big gharar) and gharar yasir (small gharar). The former should be controlled and minimized while the latter has characteristics of (i) Negligible (ii) Inevitable (iii) Unintentional; and could be borne or ignored.

RISK IN SHARIA JURISPRUDENCE

• In gharar fahish, by behavior, there are

natural gharar and created gharar.

• Natural gharar happens without any

intervention of any party like business

loss, natural disaster, asset destruction,

etc. Islamic banks may or may not

avoid this risk but can not transfer it to

other parties.

• Created gharar occurs because of human

interventional like gambling, impermissible

contracts, fake contracts, invalid

contracts, etc. Types of intervention are

taghrir al fi’li (fraudulent acts); taghrir al

qawli (fraudulent statement); taghrir

kithman (fraudulent concealment).

• Islamic banks may not do and must avoid

this created gharar because created

gharar means creating problem of

uncertainty or playing with uncertainty

condition.

RISK IN SHARIA JURISPRUDENCE

• Risk management in Islamic banking

deals with minimizing lack of

information and maximizing control

through sharia approaches such as

profit and loss sharing, al ghunmu

billa ghurmi, al kharaj bid daman,

positive or negative sum game,

cooperation and coordination and

sharia compliance business activities,

etc.

RISK IN SHARIA JURISPRUDENCE

ISLAMIC WAY OF MITIGATING RISK IN BANKS

ECONOMIC &

FINANCIAL MARKET

Exchange rate risk, RoR

risk, Inflation risk, Price

risk

Legal risk, Supervisory

risk, Systemic risk,

Monitoring risk

Withdrawal risk,

Displaced

commercial risk,

Liquidity Risk

DEPOSIT/ SOURCE

OF FUNDINGISLAMIC BANK

REAL SECTOR

FINANCING

BANKING AUTHORITY

Credit risk, Default risk,

Counterparty risk,

Settlement risk, etc

People risk, Legal risk,

Reputation risk, External risk,

Equity investment risk

Risk Sharing Risk Sharing

Coordination and

Regulation

Pure Risk

ISLAMIC BANKING OPERATIONS & RISK MANAGEMENT

Managing Risks and

in Sharia Contracts

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RISK MANAGEMENT IN MUSHARAKAH

• Musharakah is a partnership (joint venture) contract where two parties (Islamic bank and business partner) combine their capital in an investment to share profit and loss whereby they have similar right and liabilities.

• There are permanent and diminishing Musharakah.

Depositors

Profit - 3

Loss - 4

Islamic Bank Entrepreneur2

Islamic

Projects

1

• Credit, Operational, Market and Liquidity risk

exposes both permanent and diminishing

Musharakah.

• Permanent Musharakah faces operational risk

in determination of profit and loss sharing. Profit

is shared related/unrelated to capital

contribution while loss sharing is precisely

based on capital contribution.

• When business fails to produce income, it

bears credit risk. This might interrupt payment

of PLS to depositors and invite liquidity risk.

RISK MANAGEMENT IN MUSHARAKAH

• Finally if the business can not be

continued, value of final capital

faces market risk.

• Diminishing Musharakah exposes

operational risk when business

partner fails to buy share of

diminishing capital.

• Since expected income can’t be

fulfilled, credit risk appears.

RISK MANAGEMENT IN MUSHARAKAH

• When it disturbs payment of PLS to

depositors, liquidity risk comes into the

bank.

• At the end of diminishing Musharakah,

when value of total equity investment

is different with market value, banks

bears market risk.

• To handle both operational risk and

credit risk, bank must take part in

company’s management, do

monitoring and insure the business.

RISK MANAGEMENT IN MUSHARAKAH

• Bank may have right to sale its share

to third party in diminishing

Musharakah contract to avoid credit

risk.

• Stop the loss of a business is one of the

solutions to mitigate market risk.

• Gradually selling bank’s share to

business partner is also another

solution for credit and market risk.

Finally, reserving capital might hinder

bank from liquidity risk.

RISK MANAGEMENT IN MUSHARAKAH

• Mudarabah is a partnership where one party provide capital and another party provide skill. Any profit will shared but loss will be borne by owner of capital only.

1 2

4 3

5

Islamic Bank

Islamic Project

Profit

Loss

Depositors EntrepreneurPLS PLS

RISK MANAGEMENT IN MUDARABAH

• External events like catastrophic and internal

business failure might invite operational risk

ending with business losses which should be

covered by the bank.

• Following it, liquidity of the bank is disturbed

(failure to provide cash to depositors) which is

liquidity risk.

• Specifically, if mudarib is not capable (skillful)

enough to run the business, it can cause credit risk

to the bank and because value of the project

dropped in the market equity price risk appears.

• Because management of the project can’t be

controlled by bank, transparency risk exists.

RISK MANAGEMENT IN MUDARABAH

• To mitigate, bank should be sure the

eligibility and capability of the mudarib

(business partner).

• Monitoring business performance and

balance sheet of company might lessen

credit risk.

• Accurately measuring, predicting and

anticipating market risk are some ideas to

tackle market risk issue in this case.

• Providing capital adequacy and internal

reserve are also tools to prevent liquidity

risk in Mudarabah contract.

RISK MANAGEMENT IN MUDARABAH

• Mudarabah stands for a sale of good on a mutually agreed profit and deferred payment. The seller was obliged to declare his cost and the profit to the buyer (transparency) .

1b

3

4

1a 2

Bank's Client Islamic Bank

Vendor

(Owner of

the Asset)

RISK MANAGEMENT IN MURABAHAH

• Client promises to buy asset under wa’ad contract (unbinding) so it might lead to operational risk or asset risk if he/she declines to buy.

• Before asset being sold to client, bank is responsible for any risk of the asset such as market risk, risk of loss, damage, etc.

• If mark up price is not accurately determined, it may cause mark up risk.

RISK MANAGEMENT IN MURABAHAH

• At the end or during payment period of Murabahah, the bank faces commodity price risk and market risk.

• When client (buyer) fails to pay the installment, credit risk comes and if he/she is default, price and market risk bear the bank when the asset is sold to market.

• Further, such difficult situation will end up with credit liquidity risk, withdrawal risk and bank rush.

RISK MANAGEMENT IN MURABAHAH

End of the Day

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