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The University of Manchester

Manchester Business School

Risk Management in Islamic Financial Institutions

Mohamed Abdulla Ebrahim

Student registration number: 7396184

This dissertation is submitted in partial fulfilment

of the requirements for the degree of

Master of Business Administration.

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A. DECLARATION

This work has not previously been accepted in substance for any degree

and is not being concurrently submitted in candidature for any degree.

Signed……………………………………………….

Mohamed Abdulla Ebrahim

Student number: 7396184

Date 4th April 2011

STATEMENT 1

The dissertation being submitted in partial fulfilment of the requirements

for the degree of MBA

Signed……………………………………………….

Mohamed Abdulla Ebrahim

Student number: 7396184

Date 4th April 2011

STATEMENT 2

This dissertation is the result of my own independent work/investigation,

except where otherwise stated. Other sources are acknowledged by

footnotes giving explicit references. A bibliography is appended.

Signed……………………………………………….

Mohamed Abdulla Ebrahim

Student number: 7396184

Date 4th April 2011

STATEMENT 3

I hereby give my consent for my dissertation, if accepted, to be available for photocopying,

interlibrary loans and for electronic access, and for the title and

summary to be made available to outside organizations.

Signed……………………………………………….

Mohamed Abdulla Ebrahim

Student number: 7396184

Date 4th April 2011

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B. ACKNOWLEDGEMENTS

I would like to dedicate this work to Caliph/Imam Hassan Ibne Ali (A.S) fifth (5th)

and last of

the Rightly Guided (Rashidun) Caliphs, the essence of whose life‟s work was to preserve the

unity of the Ummah of his grandfather the Prophet Mohamed (PBUH), the cost of which

included his abdicating from the role of Caliph to preserve this unity. One of his sayings which

inspires me and which I would like to share is “Teach others your knowledge and learn the

knowledge of other, so you will bring your knowledge to perfection and learn something you

did not know.”

I would like acknowledge the support and contributions of my family and friends who

influenced, encouraged and supported me to do this excellent MBA. I would like to mention the

contribution of my mother Late Mrs. Shirin Ebrahim, who pushed me to pursue excellence,

loved me unconditionally and inspired me to follow the path to actualise my talents and dreams.

I am thankful to two of my former employers during whose employ I started and completed the

process of attaining the Manchester MBA, namely Ernst & Young, Mombasa, Kenya, and

Credo Investments FZE, Dubai, UAE under whose employ I completed most of the academic

coursework and allowing leave me to attend the workshops as and when required.

I would like to record my appreciation to Dr. Antony Merna for his supervision of the project

and the support he provided during the course of completing this dissertation.

I am responsible for anything controversial in the dissertation, which is not meant to undermine

any school of thought/individual, as its objective is to increase knowledge.

Mohamed Abdulla Ebrahim

April 2011

3

C. ABSTRACT

Islamic finance (Capital Markets, Banking and Insurance) has emerged from a niche financial

market to the mainstream of finance. The geographic market, clientele served, products base and

volume of funds have grown significantly. Furthermore, the players have increased and now

include not only pure Islamic institutions but also hybrid players (conventional bank with

Islamic Finance windows). Therefore, not understanding the unique risks of the Islamic Finance

model (risk sharing and risk pooling) can cause a failure of the model igniting a financial crises

with a ripple effect on the Islamic faith. Hence, managing these unique risks is extremely

important.

Purpose / Perceived Value

To increase the academic knowledge base on Risk Management in Islamic Financial Institutions

and hope some useful insights would be obtained which in turn would lead to improvement in

risk management practices in Islamic Financial Institutions. This would explore the subject of

corporate risk management in the context of Islamic Financial Institutions, which are run on the

Islamic legal and economic system, which prohibits Riba (interest), avoids Gharar (uncertainty),

avoids Maysir (gambling or excessive speculation).

Methodology

Review material on risk management, Islamic finance and risk management in Islamic financial

institutions and their basis in academic and professional knowledge already written on. Analyse

disclosures in annual financial statements of three Islamic Financial Institutions and apply these

against a Risk Management framework. Carry out a Linkedin based pilot research survey on

Risk Management practices in Islamic Financial Institutions.

4

TABLE OF CONTENTS

S/No Title/Chapter From

Page

To

Page

Cover page 0 0

A Acknowledgements 1 1

B Declaration 2 2

C Abstract 3 3

1 Introduction 5 10

2 Risk Management 11 17

3 Islamic Finance 18 26

4 Importance of Risk Management in Islamic Financial Institutions 27 38

5 Analysis of Risk Management disclosures in Financial Statements 39 51

6 Analysis of responses from Linkedin pilot survey questioner 52 58

7 Conclusions and Recommendations for Further Work 59 62

8 Bibliography 63 63

5

Chapter 1: Introduction

1.1 Background

Risk Management is gaining momentum as a subject and a professional discipline in its own

right as distinct from Corporate Governance, Internal Audit/control, Financial Reporting and

Regulatory compliance to which it is closely aligned with. This has become pertinent as the

recent global financial crises (late 2007 to 2009) which has caused the deepest recession since

the Great depression which started in 1929 and continued to throughout the 1930‟s, has been

seen widely as a failure of financial institutions to manage the risks they undertook while

transacting business.

Islamic Finance has been one of the fastest growing segments of the financial sector. At one

time a common fallacy was Islamic Finance was less riskier than conventional finance, due to

the maxims of “al-kharaj bil dhaman and al-ghunm bil ghurm”, which basically propagate the

principle of „no risk no gain‟, very much underline the recognition of risk elements in Islamic

finance. (Zaid Ibrahim & Company)1. This dissertation shall endeavour to reflect the view that

Islamic Finance is simply different with its own unique set of risks which are neither more or

less riskier than other forms of finance.

A study undertaken by the International Monetary Fund (Cihak and Hesse, 2008)2 provides

empirical evidences which verify that Islamic finance is not necessarily more or less risky than

conventional finance. The study points out, that by having profit-loss sharing financing, this

shifts the direct credit risk from banks to their investment depositors. However, it also increases

the overall degree of risk of the asset side of banks‟ balance sheets, because it makes Islamic

banks vulnerable to risks normally borne by equity investors rather than holders of debt.

It was also pointed out that, because of their compliance with the Shariah, Islamic banks can use

fewer risk hedging techniques and instruments (such as derivatives and swaps) than

conventional banks. However, it is interesting to note that because of this prohibition against the

use of derivative products and short-selling activities in the form used by its conventional

counterparts, Islamic finance were largely shielded from exposure to „toxic assets‟ such as those

arising from collateralised debt obligations (CDO) and credit default swaps (CDS). But all is

was not well when the dust settled as Islamic Finance institutions like the Kuwait based Global

Investment House was technically in solvent.

1 Demystifying Islamic Finance – Correcting misconception, advancing value propositions Zaid Ibrahim & Co.

2 Islamic Banks and Financial Stability: An Empirical Analysis Martin Čihák and Heiko Hesse (2008) IMF working paper 0816

6

1.2 Aim and Objectives

The aim of this dissertation is to explore the theory and practice of risk management in the

context of Islamic Financial institutions, which is a fast growing segment of the financial sector.

Islamic Finance is no longer a niche confined to Muslim countries in the Middle East, it is part

of mainstream finance, with London vying with Dubai and Kuala Lumpur to be the Capital of

Islamic Finance. It is believed that a lot of written material is available on both Islamic Finance

and Risk management but much less on Risk Management practices in Islamic Financial

institutions. Its aim is to show that Islamic Finance is neither more riskier nor less riskier than

conventional finance, it is simply different.

The Islamic Finance model is based on social justice as articulated in the Holy Quran and the

traditions, acts and sayings of Prophet Muhammad (PBUH). This system prohibits Interest-

Riba, excessive risk taking “Gharar” (Uncertainty, Risk or Speculation) is also prohibited and

dealing only in activities considered Halal. In essence it is based on universal ethics flavored by

a religious outlook.

Objectives

To look at Islamic Finance and the unique risks it poses due to its principles and nature.

To understand how these risks differ from risks in conventional finance,

To review how these risks are currently being addressed

How these practices can be improved.

1.3 Literature Review

The literature review would include among others the following sources

a) Published research on both Risk Management and Islamic Finance by international

organisations and professional firms like IMF, Ernst & Young etc.

b) Published books on Corporate Risk Management and Islamic Finance

c) Publication of articles on Islamic finance, Risk Management on the internet/websites.

d) Published articles related to Risk Management in Islamic Finance in Magazines.

7

1.4 Research Methodology

To achieve the stated aims and objectives, the research methodology to be as follows:-

a) Questioner on Linkedin to Professionals and advisors working in Islamic finance on risk

management practices in Islamic Financial Institutions. The questions would be based on a

risk management model i.e. how risk identification takes place, and how these risks are dealt

with or should be dealt with in their opinion. This questioner will give an insight in current

practices in Risk Management and elicit opinion on the way forward. The following

questions will be put forward to be answered by the respondents.

Part 1 based on the Risk management cycle3 (Smith, 1995) comprises of the following

questions related to each component in accordance with your knowledge and experience

related to risk management practices in Islamic Financial institutions (IFI):-

1 Identification of Risks/Uncertainties

How are potential risks identified in the IFI you are familiar with?

Is there a formal process of recording potential risks?

Who is responsible for tracking risks undertaken by the IFI (CRO, FD, CEO, CFO)?

Are risk specific to a individual major transactions separately identified?

2 Analysis of Implications

How are the implications quantified?

Are risks quantified in accordance with how often they occur?

Are risks quantified as to severity i.e. potential of loss or impact on IFI?

To whom are these reported i.e. to the Board of directors or executive management?

3 Response to minimize risk

The following are the typical responses to minimize risk for an entity, please indicate in

your opinion the percentage of occurrences the particular response is chosen? Total 100%

Risk Avoidance (declining transaction)

Risk reduction (maybe by syndication)

Risk transfer (hedging or insurance)

Risk retention (accept the risk)

4 Allocation of appropriate contingencies

How is the desirable/acceptable level of risk determined?

How are resources allocated to ensure the overall risk level is acceptable?

Are contingency plans put place should the risk materialize?

If yes, how are these communicated to the members of the organization?

3 Corporate Risk Management – Tony Merna and Faisal F Al Thani 2nd edition 2010

8

Part 2 Objective is to elicit opinion on way forward on improving the practice of risk

management in Islamic Financial Institutions.

In your opinion is the state of risk management practice adequate for the needs of the IFI,

you are familiar with?

In your view what are the three key improvements that should be made to make the risk

management process better?

The following are the Global Top 10 risks as Identified in The Ernst & Young Business Risk

Report 2010 4(2009 rank in brackets), please rank the risks in your opinion as they apply to

Islamic Financial Institutions:

1. Regulation and compliance (2)

2. Access to credit/funding (1)

3 Slow recovery or double-dip recession (No change)

4. Managing talent (7)

5. Emerging markets (12)

6. Cost cutting (No change)

7. Non-traditional entrants (5)

8. Radical greening (4)

9. Social acceptance risk and corporate social responsibility (New)

10. Executing alliances and transactions (8)

b) Analytical synthesis of publicly available information regarding risk management in Annual

Reports of the following three Islamic Financial Institutions Meezan Bank (Pakistan), Al

Baraka Banking group (Bahrain but operating through out the Middle East and North

African region) and Khaleej Takaful - Insurance (Dubai) .

1.5 Limitations of the Research

The research is limited to the responses of members of Linkedin groups with interest in

Islamic Finance and to the publicly disclosed information in Annual Financial Statements of

the three selected Islamic Financial Institutions. Hence it will not be having information on

detailed risk management practices in the selected Institutions and in other Islamic Financial

Institutions. The opinion on the way forward will be limited to the views of the respondents

of the questioner.

4 The Ernst & Young Business Risk Report 2010

9

1.6 Scope of Dissertation

The scope of the dissertation will be to explore the risk management practices in Islamic

Financial Institutions, by reviewing the currently published literature and responses on Risk

Management practices and propose a way forward to improve these practices. This will be

structured in chapters as described below:-

Chapter 2 - Risk Management

This will Introduce Risk Management, exploring what risk management can achieve to enhance

value to a business. Then I will introduce the concept of risk and uncertainty. Thereafter the risk

management process/cycle. Finally the available tools and techniques used to mitigate, share or

transfer risk.

Chapter3 – Islamic Finance

This chapter will introduce the reader to the background and general principles governing

Islamic Finance. Then each section will look at the different general products of Islamic Finance

which includes Islamic Banking, Islamic Insurance – Takaful and Islamic Capital markets.

Chapter 4: Importance of Risk Management in Islamic Finance

This chapter will attempt to identify risks unique to the Islamic economic model, the threats

posed by risks peculiar to Islamic Finance, how to deal with these risks identified,

Islamic financial instruments which may be considered both to aggravate risk and to

mitigate risk depending on the context.

Chapter 5: Analysis of Risk Management disclosures in Financial Statements

This chapter will present the analysis of the risk management disclosures in the financial

statements of Meezan Bank based in Pakistan, Khaleej Takaful an Islamic insurance company

based in Dubai, United Arab Emirates and Al Baraka banking group headquartered in Manama,

Bahrain but having a pan Arab base operating through various subsidiaries in Middle East and

North Africa region.

10

Chapter 6: Analysis of responses from Linkedin questioner

This chapter will analyse the responses from the Questioner for members of Groups on Islamic

Finance on Linkedin and CIMA Islamic Finance forum on their perception of Risk Management

in Islamic Finance Institutions and the Questioner for people working in Islamic Financial

institutions and are members of groups in Linkedin and CIMA Islamic Finance Forum. I shall

then endeavour to synthesis the findings of the analysis and suggest on the way forward to

improve practice of risk management in Islamic Financial Institutions.

Chapter 7: Conclusions and Recommendations for Further Work

This chapter will present a summary of the dissertation, its findings and draw conclusions. It

will also attempt to suggest the way forward to improve risk management practises in Islamic

Financial Institutions. Lastly it will make recommendation for further work in this area

especially the interplay between corporate governance and risk management in Islamic

Financial Institutions.

11

Chapter 2: Risk Management

2.1 Introduction

This chapter will give a background to risk management and its development as a discipline.

Thereafter it will look at the relationship between risk and uncertainty, from which the

dissertation will discuss the risk management process, finally it will discuss the tools and

techniques used. Risk Management has numerous definitions usually based on the context in

which it is being discussed among these are:

“Risk management is formal process that enables the identification, assessment, planning and

management of risk.” 5(Merna and Al Thani 2010)

COSO ERM defines enterprise risk management as a process designed to identify potential

events that may effect the entity, and manage risk to be within its risk appetite, to provide

reasonable assurance regarding the achievement of entity objectives. The process is effected by

an entity‟s board of directors, management and other personnel, applied in strategy setting and

across the enterprise. 6

ASNZ 4360 states that risk management is an integral part of good business practice and quality

management. The standard further specifies that risk management means inter alia identifying

and taking opportunities to improve performance as well as taking action to avoid or reduce the

chances of something going wrong.7

The Institute of Risk Management in its risk management standard says Risk can be defined as

the combination of the probability of an event and its consequences (ISO/IEC Guide 73). In all

types of undertaking, there is potential for events and consequences that constitute opportunities

for benefit (upside) or threats to success (downside). Risk Management is increasingly

recognised as being concerned with both positive and negative aspects of risk. Therefore this

standard considers risk from both perspectives.8

The common theme arising from the various definitions are that risk management is a

management process to deal with uncertainties faced by any entity, threats to its resources and

its consequences, as it chooses the opportunities presented by its operating environment, to

increase the value of the entity.

5 Corporate Risk Management 2

nd edition Tony Merna and Faisal F Al Thani

6 COSO ERM

7 ASNZ 4360

8 A Risk Management Standard - http://www.theirm.org/publications/documents/ARMS_2002_IRM.pdf

(Assessed 26 February 2011)

12

2.2 Risks faced by an Islamic Financial institution

Common risks faced by an Islamic Financial Institution are shown in Figure 2.1 (author‟s own)

below:

Price risk is the context of an Islamic Financial Institution is that the value of the underlying

commodity or asset which forms the basis of the contract between the Islamic financial

institution and the financed party will vary from the original price. The exchange rate risk arises

when the rate of exchange fluctuates for its funding and also financing transaction.

Credit risk is the uncertainty of the financed party being unable to meet its obligations to the

Islamic Financial Institution as and when they fall due. This is a speculative risk undertaken

with an objective of a gain, with the possibility of a loss.

Profit rate risk is the risk that the profit generated from partnership contracts will not be as

envisaged or the profit rate indicated to the institutions investment account holders will not be

sufficient or balanced. Furthermore, some investment account holders benchmark this profit rate

with interest rates offer by conventional banks, and can move their funds to conventional

financial institutions.

Liquidity risk arises due to two main reasons, firstly the inherent mismatch been the term of the

source of funds (deposits which are mainly short-term) and the destination of the funds (project

funding which are mainly long-term) and secondly the risk that the funds raised by the Islamic

Financial Institution from the Capital markets in form of Sukuk‟s and expected to be repaid and

at that point in time there is no appetite from buyers to purchase the new issue.

Pure risks are risks for which there is potential for only a downside and is best exemplified by

damage to owned assets or property and legal liability due to being sued by third parties like

customers and employees among others.

Risks faced by IFI’s

Price Risk Credit Risk Pure Risks

Liquidity Risk

Commodity or

Asset Price Risk

Exchange

Rate Risk Damage to assets Legal Liability

Profit Rate Risk

13

Key Drivers of Risk- Figure 2.2

(Adapted from A Risk Management Standard – Institute of Risk Management)

Externally Driven

Financial Risks Strategic Risks

Foreign Exchange Risk Competition

Interest Rate Risk/Profit rate Customer Changes and Demands

Credit Risks Industry Structure Changes

Liquidity and cash flow Research and product development

Internally Driven

Accounting controls Products and Services

Information systems Legal Contracts

National Culture and Regulations Property destruction

Operational Risks Hazard Risks

Externally Driven

Internally Driven

Externally Driven

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2.3 The Concept of Risk and Uncertainty

Risk is simply defined as a probability of a loss or gain. One situation is riskier than another if it

has a greater expected loss or a greater uncertainty (defined as the variability around the

expected loss).9 Therefore risk is linked to the quantum of loss or profit (risk reward ratio) i.e.

the probability of an event occurring causing either a gain or loss and how much the gain/loss

varies from the expected outcome which is an average.

Business inevitable has to undertake risk in its daily activities as perfect information is a myth.

Risk is usually thought of in respect of a negative event happening, the probability of it

happening and the quantum of the loss when it occurs. Uncertainty is said to exist in a business

transaction whereby the decision-makers lack complete knowledge, information or

understanding of the proposed transaction and its possible consequences.

In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established the

distinction between risk and uncertainty.10

“Uncertainty must be taken in a sense radically

distinct from the familiar notion of Risk, from which it has never been properly separated. The

term "risk," as loosely used in everyday speech and in economic discussion, really covers two

things which, functionally at least, in their causal relations to the phenomena of economic

organization, are categorically different. The essential fact is that "risk" means in some cases a

quantity susceptible of measurement, while at other times it is something distinctly not of this

character; and there are far-reaching and crucial differences in the bearings of the phenomenon

depending on which of the two is really present and operating. ... It will appear that a

measurable uncertainty, or "risk" proper, as we shall use the term, is so far different from an

unmeasurable one that it is not in effect an uncertainty at all. We accordingly restrict the term

"uncertainty" to cases of the non-quantitive type.

9 Risk Management & Insurance 2

nd edition Harrington and Niehaus

10 http://en.wikipedia.org/wiki/Risk accessed on 26 February 2011

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2.4 The Risk Management Process

Risk Management deals both with insurable as well as uninsurable risks and is an approach

which involves a formal orderly process for systematically identifying, analysing and

responding to risk events.1 (Merna & Al Thani 2010).

A diagrammatic representation of the Risk Management Process Figure 2.3 adapted from A

Risk Management Standard by the Institute of Risk Management4

Definitions

Risk Assessment: Is the overall process of risk analysis and risk evaluation.

Risk Reporting: Threats & Opportunities to Board of Director & affected Business Managers

Risk Treatment: Is the process of selecting and implementing measures to modify the risk.

Residual Risk Reporting: to its stakeholders on a regular basis setting out its risk management

policies and the effectiveness in achieving its objectives

Monitoring: This process provides assurance that there are appropriate controls in place for the

organisation‟s activities and that the procedures are understood and followed.

Organisation’s Strategic Objectives

Risk Assessment

Risk Analysis - Risk Identification - Risk Description - Risk Estimation

Risk Evaluation Risk Reporting: Threats and Opportunities

Th

Risk Treatment

Residual Risk Reporting

Monitoring

Modifications Formal Audit

16

There are two major dimensions of a loss exposure are the loss frequency and loss severity.

Loss frequency is measured by probability of the occurrence of an event based on past

experience. Loss severity is measured by maximum possible loss and expected loss. Hence

classification of risk in accordance with these two dimensions is the starting point in managing

risk. In the view of business it is sensible to focus on exposures to risks rather than the potential

upside. The key exposures to risk in any organisation are physical asset exposures, legal liability

exposures, human resource exposure and financial asset exposures.

2.5 Risk Management Tools and Techniques

There are two major categories of risk management tools and techniques used by risk

professionals to analyse risk namely Quantitative techniques and Qualitative techniques, which

are applied to the dimensions of loss exposures. Qualitative techniques seek to compare the

relative significance of risk faced by an enterprise in terms of the consequences to it.

Quantitative techniques and tools attempt to determine absolute value ranges, using statistical

tools like probability distributions to quantify probable outcome.

Qualitative Techniques for risk management include Brainstorming, Assumption Analysis,

Delphi, Interviews, Hazard and Operability Studies (HAZOP), Failure Modes and Effect

Criticality Analysis (FMECA), Checklist, Prompt list, Risk Registers, Risk Mapping,

Probability Impact Tables, Risk Matrix Chart, Project Risk Management Road Mapping.

Quantitative techniques for risk management include Decision Trees, Controlled Interval and

Memory Technique, Monte Carlo Simulation, Sensitivity Analysis and Probability-Impact Grid

Analysis.

Other techniques include Soft Systems Methodology, Utility Theory, Risk attitude and Utility

Theory, Nominal Group Technique, Stress Testing and Deterministic Analysis, Tornado

Diagram, Country Risk Analysis and Political Risk Analysis.

Risk Control techniques include Risk Avoidance by not undertaking the activity which can lead

to a loss, Loss Control which include Loss prevention (reducing the frequency of losses) and

Loss reduction (reducing the severity of losses), Risk Separation this reduces the probability

that several losses will at the same time , Risk Combination/pooling increases the predictability

of losses through the law of large numbers and Risk Transfer which can include transferring the

cause of the risk, transferring the risk itself, transferring the cause of the risk and transferring the

consequence of the risk through insurance.

17

Contracts can be used to mitigate or transfer risk like insurance contracts for hazard (pure risks

like theft, fire etc), derivative contracts (options, forwards, futures and swaps) to mitigate

against financial risks like commodity prices, foreign exchange risks, interest rate risks and

contracts where risk is transferred to the counterparty through legal clauses.

The choice of the technique whether to assess the risk or alter the risk depends on the context of

the situation, availability and the resources including time and money to the organisation.

Hence, there is no one set of techniques to ensure universal applicability.

2.6 Summary

Risk management should be embedded within the organisation through the strategy and budget

processes. It should be highlighted in induction and all other training and development as well

as within operational processes e.g. product/service development projects. The Board has the

overall responsibility for determining the strategic direction of the organisation and for creating

the environment and the structures for risk management to operate effectively. There should be

a risk champion on the board to ensure the board is aware of the risks under taken by the entity

and decide whether these are acceptable. Business unit managers s have primary responsibility

for managing risk on a day to-day basis, hence risk management should be a regular

management-meeting item to allow consideration of exposures and to reprioritise work in the

light of effective risk analysis. The same awareness of risk issues is also required for those

involved in the audit and review of internal controls and facilitating the risk management

process and includes both the internal audit function and external auditors.

18

Chapter 3: Islamic Finance

3.1 Introduction

Islamic finance constitutes the fastest growing segment of the financial system in the world.

Modern Islamic banking started about three decades ago, the number and reach of Islamic

financial institutions worldwide has risen from one institution in one country in 1975 to over

300 institutions operating in more than 75 countries (El Qorchi, 2005)11

. In Sudan and Iran, the

entire banking system is currently based on Islamic finance principles. However the roots of the

Islamic Banking system goes back back through time to the profit and loss sharing principles in

the Code of Hammurabi in the 18th century BCE. Over the centuries, philosophers and

theologians alike have debated the issues surrounding justness of exchange and the charging of

interest. Charging of interest is long seen as damaging to individuals as well as the economy by

the majority of theologians and philosophers. Even the Christian Holy Bible and Jewish Holy

Torah forbid Usury. This chapter will explore the general principle of Islamic Finance, briefly

going into the sources of Islamic Law without going into the details of the various schools of

thought which are contentious issues even among Islamic scholars depending on whether they

are Sunni or Shia, region from which they come from (scholars from some regions are more

liberal than others). There are Islamic Scholars who have approved derivative s contracts

(forward, swaps and options), while other scholars consider these as unlawful. An example

would be HH Prince Karim Aga Khan IV Imam to Nizari Ismaili Shia Muslims, direct lineal

male descendant of the Prophet Mohamed (PBUH) and widely respected in the Muslim

community worldwide has a different opinion on the interest which is not usury therefore not

“Riba” which is prohibited in the Quran, hence he has significant interests in conventional

banking institutions both in the developed and developing world, which is significantly altering

the economic lives of people living in those countries. In the other end of the Shia spectrum lies

the Mustali Ismaili Shia Muslims, in whose view even instalment sale contracts where the

current cash price and instalment sale price differ is considered unlawful and profit loss sharing

without the investor being actively involved in the business is prohibited, This based on the

principle, all earnings have to be from the individuals sweat, law of one price and avoidance of

excessive profit. Then it will give a bird‟s eye view of Islamic Banking, which is a banking

system that is based on the principles of Islamic law and guided by Islamic economics. Two

basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the

prohibition of the collection and payment of interest. Collecting interest is not permitted under

Islamic law.

11 IMF Working Paper WP/08/16 Islamic Banks and Financial Stability: An Empirical Analysis

Prepared by Martin Čihák and Heiko Hesse

19

Thereafter, we shall take a peek into the world of Islamic insurance – Takaful, which is based

on risk pooling and sharing rather than risk transfer. Takaful is where members contribute

money into a pooling system in order to guarantee each other against loss or damage. Takaful is

based on Islamic religious law, and is based on the responsibility of individuals to cooperate and

protect each other. Lastly, it will explore Islamic Capital Markets products the most well know

is the Islamic bond called a Sukuk. Since interest is prohibited Sukuks must be able to link

the returns and cash flows of the financing to the assets purchased, or the returns generated from

an asset purchased. This is because trading in debt is prohibited under Sharia. As

such, financing must only be raised for identifiable assets. It can be compared to a sale,

lease/rent and buy back transaction in conventional finance.

3.2 Islamic Finance general principles

The guiding principles of Islamic Finance are based on Islamic Law (Sharia) as documented in

the Holy Quran and promulgated in the Sunnah (Hadith - sayings and living habits/acts of

Prophet Mohamed (PBUH), which are universally accepted by all Muslims. Different schools

of jurisprudence both Sunni and Shia place different level of emphasis on secondary sources

like Ijma (consensus of Scholars), Ijtihad (independent legal reasoning), Qiyas (analogical

deduction), Aql (use intellect to find general principles applicable in the situation from the Holy

Quran and Sunnah ), saying and acts of Shia Imams who are descendents of Prophet Mohamed

–PBUH according to Shia beliefs they are responsible for guiding the Muslims ummah and

interpreting the Holy Quran according to the changing time and space, Urf (common practices

of a given society not addressed in the Holy Quran and Sunnah) and Al-Maslaha Al-Mursalah

(Maliki Sunni) "underlying meaning of the revealed text in the light of public interest". 12

Islamic Finance is based on the prohibition of interest ("Riba"), excessive uncertainty

("Gharar") and gambling ("Maysir" or "Qimar"). Being Sharia compliant also means that the

funding should not be for the purposes of haram (prohibited activities) like pornography,

building a brewery or casino or a pork farm etc. Judaism and Christianity also prohibit usury

(interest) in their religious texts the Torah and Bible respectively. Holy Quran commands honest

fulfilment of all contracts (al-Maidah: 1); prohibits the betrayal of any trust (al-anfal: 27);

forbids the earning of income from cheating, price manipulation, dishonesty or fraud (an-nisa‟a:

29); shuns the use of bribery to derive undue advantage (al-baqarah: 188); and promotes clarity

in contracts to minimise manipulation from dubious ambiguity (al-baqarah: 282)

12

http://en.wikipedia.org/wiki/Sources_of_Islamic_law (accessed 14th March 2011)

20

3.3 Islamic Banking

The roots of Islamic banking goes to the time of the establishment of the Islamic Arab empire -

the Caliphate which conquered vast areas in Middle Central Asia, North Africa and parts of

Europe in the 7th Century, where systems of payments and finance were required which

included Qardan Hasannah (interest free loan), Hawallah (promissory notes/ bills of exchange),

a currency (Dinar), Waqf (trusts), to facilitate trade and mercantilism and pay the employees of

the Islamic state. However, this dissertation shall focus on modern Islamic banking, which is

based on the following concepts - Definitions adapted from FAS 1 issued by AAOIFI13

:-

Mudarabha - A partnership in profit between capital and labour. It may be conducted

between investment account holders as providers of funds and the Islamic bank as a

mudarib. The Islamic bank announces its willingness to accept the funds of investment

amount holders, the sharing of profits being as agreed between the two parties, and the

losses being borne by the provider of funds except if they were due to misconduct,

negligence or violation of the conditions agreed upon by the Islamic bank. In the latter

cases, such losses would be borne by the Islamic bank. A Mudarabha contract may also

be concluded between the Islamic bank, as a provider of funds, on behalf of itself or on

behalf of investment account holders, and business owners and craftsmen.

Salam : - Purchase of a commodity for deferred delivery in exchange for immediate payment

according to specified conditions or sale of a commodity for deferred delivery in exchange for

immediate payment.

Murabaha : - Sale of goods with an agreed upon profit mark up on the cost. Murabaha sale is

of two types. In the first type, the Islamic bank purchases the goods and makes it available for

sale without any prior promise from a customer to purchase it. In the second type, the Islamic

bank purchases the goods ordered by a customer from a third party and then sells these goods to

the same customer. In the latter case, the Islamic bank purchases the goods only after a customer

has made a promise to purchase them from the bank.

Musharaka : - A form of partnership between the Islamic bank and its clients whereby each

party contributes to the capital of partnership in equal or varying degrees to establish a new

project or share in an existing one, and whereby each of the parties becomes an owner of the

capital on a permanent or declining basis and shall have his due share of profits. However,

13 Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI)

http://www.aaoifi.com/aaoifi/Definitions/tabid/209/language/en-US/Default.aspx (accessed 14 March 2011)

21

losses are shared in proportion to the contributed capital. It is not permissible to stipulate

otherwise.

Istisna’a : - A contract whereby the purchaser asks the seller to manufacture a specifically

defined product using the seller‟s raw materials at a given price. The contractual agreement of

Istisna‟ has characteristic similar to that of Salam in that it provides for the sale of a product not

available at the time of sale. It also has a characteristic similar to the ordinary sale in that the

price may be paid on credit; however, unlike Salam, the price in the Istisna‟ contract is not paid

when the deal is concluded.

Ijarah and Ijarah Wa Iktana:- A lease agreement (similar to a hire purchase agreement)

whereby instead of lending money and earning interest, the Islamic bank purchases the asset and

rents it to the party requiring the asset and earns rental income. In ijarah wa iktana the renter

agrees to buy the asset at a nominal price at the end of the contract, in ijarah there is no such

agreement to purchase the asset.

3.4 Islamic Insurance – Takaful

Takaful is an Arabic word meaning guaranteeing each other. An Islamic insurance

(Takaful) industry observing the rules and regulations of Islamic Sharia law has

developed in recent years, which in common with Islamic banking avoids interest,

excessive uncertainty and gambling. However this concept has been practiced in various

forms for over 1400 years based on shared responsibility in the system of aquila as

practiced between Muslims of Mecca and Medina, which laid the foundation of mutual

assistance insurance – Takaful based on risk pooling and sharing today. Although some

Muslim scholars consider any form of insurance to be against the concept that Muslims

believe in God, who is the provider and sustainer of all and is based on the following

verse from the Holy Quran “Who, when a misfortune overtakes them, say: 'Surely we

belong to Allah and to Him shall we return'.". (Sura Al-Baqara, Verse 156)

Takaful is based on the concept of social solidarity, cooperation and mutual

indemnification of losses of members. It is a pact among a group of persons who agree

to jointly indemnify the loss or damage that may inflict upon any of them, out of the

fund they donate collectively. The Takaful contract so agreed usually involves the

concepts of Mudarabah (partnership in profit), Tabarru´ (to donate for benefit of others)

and Ta-Awun (mutual assistance or sharing of losses) with the overall objective of

22

eliminating the element of uncertainty. Even though all Muslims believe in the will of

Allah who is the owner of everything and we are merely his stewards, the steward had a

duty to protect the assets given to him in trust by the owner, hence justification for a

Sharia compliant Islamic alternative Takaful to conventional insurance. This view point

for Takaful is justified based on the following Islamic jurisprudence sources14

.

Basis of Co-operation Help one another in al-Birr and in al-Taqwa (virtue, righteousness and

piety): but do not help one another in sin and transgression. (Holy Quran Surah Al-Maidah,

Verse 2) and Allah will always help His servant for as long as he helps others. (Hadith Narrated

by Imam Ahmad bin Hanbal and Imam Abu Daud)

Basis of Responsibility The place of relationships and feelings of people with faith, between

each other, is just like the body; when one of its parts is afflicted with pain, then the rest of the

body will be affected. (Narrated by Imam al-Bukhari and Imam Muslim)

One true Muslim (Mu‟min) and another true Muslim (Mu‟min) is just like a building whereby

every part in it strengthens the other part. (Narrated by Imam al-Bukhari and Imam Muslim)

Basis of Mutual Protection: - By my life, which is in Allah‟s Power, nobody will enter Paradise

if he does not protect his neighbor who is in distress. (Narrated by Imam Ahmad bin Hanbal)

Key Elements of Takaful

Mutual Guarantee: Loss covered by donations of members in fund which pays out losses.

Ownership of Fund: Contributors are owners of fund, hence entitled to the profit.

Elimination of uncertainty: Donations are voluntary and no pre-determined benefits.

Management of Takaful Fund: Operator uses either Mudaraba (Partnership) or Wakala

(Principal Agent relationship ) contract to manage funds, which are Sharia compliant.

Investments Conditions: Avoids interest and haram (prohibited) activities for investment.

14

http://en.wikipedia.org/wiki/Takaful (accessed on 14 March 2011)

23

3.5 Islamic capital markets

There are two major components of Islamic capital markets namely Sukuk‟s (Sharia compliant

bonds) and Islamic investment funds. Using the double entry sheet terminology the Sukuk sits

on the credit side of the balance sheet hence is a liability, while Islamic investment funds sit on

the debit side of the balance sheet hence an asset. Both the capital market instruments are

market traded on organised stock exchanges, with some restrictions on the tradability of debt

instruments.

Sukuk is the Arabic word for financial certificate, commonly analogous to a bond (promise to

pay) in conventional finance. It is asset based rather than asset backed to comply with sharia

requirements. The beauty of the Sukuk lies in asset securitisation, whereby future cash flows

emanating from an asset are converted into present cash flow. A sukuk can be created on an

existing asset and also on a future asset which is being created. The sukuk can be structured as

Sukuk Murabaha which constitutes partial ownership in a debt, Sukuk Al Ijara which is asset

backed, Sukuk Al Istisna which is project backed, Sukuk Al Musharaka which is business

backed or Sukuk Al Istithmar which is an investment. From a strict sharia perspective debt

certificates are not tradable at a price other than at par or face value, as any money generated

from holding money is considered interest which is prohibited, hence most sukuk instruments

are held to maturity. Therefore the secondary market although in exists but has limited trades.

An Islamic investment fund is a Sharia compliant fund which invests in halal activites, avoids

excessive uncertainty, avoid interest and is not overly speculative (gamble). These can be

structured as a mutual fund, a hedge fund or electronic traded fund (ETF).

The common types of investments funds are commodity funds, equity funds, murabaha

funds and Ijara funds.

Commodities funds generate profits by buying and reselling commodities. Due to the

restrictions on the use of derivatives, commodities fund make use of two types of contracts:

1. Istina‟a- It‟s a contract where the buyer of an item funds upfront the production of the

item. A detailed specification of the item as to be agreed before production starts and

the cost of production has to be paid in full when the contract is agreed.

2. Bay al-salam which is similar to a forward contract where the buyer pays in advance for

the delivery of raw materials or tangible goods at a later date.

Equity funds invest in equity shares of companies engaged in halal business activities. These are

similar to ethical investing funds.

24

Murabaha funds are similar to development funds, and use the „cost-plus‟ financing model,

where a fund will buy goods and sell them to a third party at a given price. The price is made of

the cost of goods plus a profit margin.

Ijara Funds acquire and keep ownership of an asset (real estate, machinery, vehicles or

equipment) and then makes profits by leasing it out in return of a rental payment. The fund is

responsible for the management of the assets and will earns a management fee. This is similar to

Real Estate Investments Trusts (REITs) and Energy Royalty Trusts (common in Canada).

3.6 Differences between Islamic Finance and Conventional Finance instruments

Sukuk and Bonds

Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines a

sukuk as being: “Certificates of equal value representing after closing subscription, receipt of

the value of the certificates and putting it to use as planned, common title to shares and rights in

tangible assets, usufructs and services, or equity of a given project or equity of a special

investment activity”. Hence, it is a mezzanine financial instrument that is neither debt nor

equity, created by a process of securitization of cash flow and ownership of an asset or project.

The sukuk holder shares in the cash flow generated by the asset and the disposition proceed of

the assets. A bond on the other hand is a contractually obligation to pay to bondholders, on

certain specified dates, interest and principal.

Takaful and Insurance

Takaful is based on the principles on mutual assistance and voluntary contribution in a pool of

funds to be shared among those in the group afflicted by perils or calamities, without guarantees

that the fund will be adequate of expectation that the operator will earn a profit. In conventional

insurance the insurer collects premium from the insured to cover expected payout and profit,

this is akin to speculation (Maysir) which is forbidden in Islamic Finance. The insurer pays

premiums to be covered for risks that may or may not materialize, this is uncertainty (Gharar),

which is also forbidden in Islamic Finance. Lastly, the premiums collected are invested to earn

interest (usury) which is forbidden in Islamic Finance.

3.7 Summary

The basic principles underlying the Islamic Finance concept are very similar to ethical

investing, co-operative arrangements, and mutual principles, very closely aligned to

conventional financial products but avoiding interest, excessive uncertainty and speculation.

25

Chapter 4: Importance of Risk Management in Islamic Finance

4.1 Introduction

Product complexity in Islamic Finance has increased as there is a trend to develop an Islamic

variant for most products in non-Islamic finance, but the pace in risk management practices has

not developed at the same rate. This has been attributed (Ahsan Ali, December 2009)15

to the

following:-

Lack of Standardised product descriptions and attributes within Islamic Finance.

Lack of understanding of Islamic structures and therefore, weak regulatory frameworks

within countries to manage Islamic Financial Institutions (IFIs).

Limited data on Islamic transaction and low technological adaptability for technology-based

risk management models.

Concentration of Islamic Finance institutions in emerging markets, where the risk

management techniques for both conventional and Islamic modes of financing lag the

developed markets.

Due to the above reasons it is (Ahsan Ali, 2009)15

postulated that Islamic Financial Institutions

are inherently riskier propositions than their conventional counterparts.

The above arguments can be countered by the following:-

Standardisation of product descriptions, Islamic Finance Structures and accounting

attributes are taking places through the efforts of Accounting and Auditing Organization for

Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB).

However, having two bodies with similar objectives and membership of which is voluntary

by Islamic Financial Institutions creates confusion in the perception of the general public.

Furthermore, there is weak enforcement capability as these organizations do not have

credible sanctions mechanisms, to enforce application of standards set.

Islamic Finance is no longer confined to the developing world as London and New York are

becoming major centers for Islamic Capital Market products, hence risk management

techniques are improving and technological developments will catch up.

The data availability is increasing especially in Malaysia and Gulf markets, with

publications like Business Islamica, Gulf news quarterly and Global Islamic Finance.

15

Risk Management Integral to the Future of Islamic Finance – Article in Business Islamica December

2009

26

Risk management in Islamic Finance is driven by the principles of Islamic economics which are

derived from the Holy Quran and Sunnah of Prophet Mohamed (PBUH). Hence it is prone to

the usual risks faced by all financial institutions plus risks which affect primarily Islamic

Financial Institutions. The importance of the concept of risk management in Islamic Finance is

emphasised by the following verse in the Holy Quran and Saying of Prophet Mohamed (PBUH)

Further he said: "O my sons! Do not enter the capital of Egypt by one gate: but go into it by

different gates. However know it well that I cannot ward off you Allah‟s will for none other

than He has nay authority whatsoever. On Him do I put my trust and all who want to rely upon

anyone should put their trust on Him alone." (Surah Yusuf: Verse 67)

Prophet Muhammad noticed a Bedouin leaving his camel without tying it and he asked the

Bedouin “Why didn‟t you tie down your camel?” The Bedouin answered, “I put my trust in

God.” Muhammad replied, “Tie your camel and put your trust in God.”

In this chapter the author shall identify risks faced by Islamic Financial Institutions, look at risk

affected due to its economic model or how normal business risks uniquely affect them. Then the

author shall look at threats posed by these risks and consequently how those risks can be dealt

with. Finally it shall discuss Islamic Financial Instruments which are used in Islamic Finance

which mitigate certain risks but create a different type of risk for an IFI.

4.2 Identification of risks in the Islamic Finance economic model

Credit Risk

This is the risk whereby the borrower defaults on the loan. In the Islamic Financial Institution‟s

(IFI‟s) context this means the counter party defaults on its contractual obligation and the IFI has

to foreclose on the underlying asset, this becomes particularly challenging in the instance of

residential real estate instalment sale transaction, which would conflict with its responsibility to

society. It is important to note that IFI‟s generally have greater exposure to real estate than

conventional banks, where the bank becomes owner of the asset which according to IFRS this

needs to be incorporated on its balance sheet, which creates additional volatility in its reported

earnings. Furthermore greater focus on asset financing through Ijara (leasing) and Murabaha

(sale with profit mark-up), may cause a tendency to overlook credit worthiness and ability to

repay of the counterparty.

Market Risk

Hedging using conventional derivatives is restricted, as some scholars consider it to be Maysir

(gambling) which is prohibited, hence the possibility of a higher than normal margin risk

27

especially in fixed margin Murabaha (sale with profit mark up) i.e. mismatch between what is

earned on the assets and what is paid out on its investment accounts. These restriction leads to

artificial inflation of values of investment opportunities as too much capital is chasing too few

assets. Furthermore, IFI‟s run a higher foreign exchange risk on their balance sheets particularly

translation risk for banks with operation in multiple countries, which have to be consolidated as

per IFRS requirements, due to limited opportunities to hedge.

Operational Risk

IFI‟s have to ensure correct processing and sequential documentation for most of its

transactions, as any error invalidates the entire transactions and profit has to be donated.

Liquidity Risk

This is higher in IFI‟s as the secondary market for Islamic Capital market instruments is

underdeveloped, due to prohibition in sale of debt at a price other than at par. Thus most Islamic

Capital market instruments are held to maturity, which restricts the ability to realise cash when

required repay investment account holders, hence a minor run on an IFI can have a major effect

on its solvency, as it cannot access its central bank as lender of last resort.

Reputational Risk

This is higher in IFI‟s due to the risk of Sharia compliance requirements, while Sharia decrees

and decisions are not standardised or follow the principles of judicial precedence as in English

common law. Sharia boards are made up of scholars, who sometimes disagree on products lines

like Tawaruk (Shariah-compliant of finance through which loan finance is raised by buying

installments in local commodities that are owned by the bank) which is acceptable to certain

scholars and prohibited by others. The Sharia board of an IFI can be changed to get scholars

who are compliant to the wishes of the IFI‟s owners, hence they could be accused of “scholar

shopping or fatwa shopping” which has the potential to damage its reputation in the eyes of

Investment Account holders. This happened in Dubai during the recent global financial crises

when some real estate developers wished to change the underlying assets of instruments in a

process of consolidation of projects, which were considered unacceptable to certain scholars.

Furthermore, fatwa‟s issued by prominent scholars not on the IFI‟s Sharia board also tend to

influence behaviour of market participants.

28

Classical Islamic Law 16

classified risk in into three categories as follows:-

1. Essential risk and al-kharāj bi-dhaman, which can be roughly translated as „the profit belongs to

him who bears responsibility‟. This maxim encapsulates the concept of risk for return (al ghunm

bil ghurm). Parties who enter into an agreement are entitled to its benefit as long as there is

some form of associated risk. Without the risk, the transaction would not be shari‟a compliant.

Any condition to the contrary would make the transaction void, such as anything contrary to the

rule on a total or partial loss or decrease in value of an asset is on account of its owner). If one

requires a return of some form, then one should be able to take on the associated level of risk. In

an Islamic sales contract, the seller bears all the risks of loss of the asset until title is transferred

to the buyer who then in turn takes on the full risks, including risks of defect, damage or

depreciation arising thereafter. In an Islamic leasing arrangement, the lessor assumes all risks of

loss (not caused by the lessee) and the risks of maintenance and payments of taxes. Whereas the

lessee assumes the risks of rental payment, of any loss of profit and of under-utilisation

associated with the rental of the asset. In a mudaraba arrangement, the risk of loss, damage or

decrease in value of the mudaraba assets and capital is borne by the investor (rab al mal) as long

as there is no default, misconduct or breach by the investment manager (mudarib).

2. Gharar Katheer, which can be roughly translated as „excessive/gross uncertainty or speculation‟.

Muslims are strictly prohibited from entering into this second category of risks as such risks

make a transaction or a contract void from a shari‟a perspective. Whereas in conventional

finance, this is a form of tradable risk which can be separated and sold on, or, which can be

mitigated against. This form of risk is also known as gharar jaseem and it can be further

classified into the following sub-types of prohibited risks:

a. Risk in Existence (i.e., the sale of an non-existent item, such as crops, on a future basis);

b. Risk in taking Possession (i.e., the sale of a run-away camel or commodity / property that

has to be repossessed);

c. Risk in Quantity (i.e., sale price or rent being unknown in a sale or lease contract);

d. Risk in Quality (i.e., type, quantity or specifications of the subject matter of contract being

unknown); and

e. Risk in Time of Payment (i.e., a deferred sale without fixing the exact period).

16 Islamic Finance project Harvard Law School, Islamic Legal Studies Program, Harvard-LSE Workshop London

School of Economics 26 February 2009 Workshop on Risk Management: Islamic Economic and Islamic EthicoLegal

Perspectives on the Current Financial Crisis – A short Report Prepared by Husam El-Khatib Introduction by Zohaib

Patel.

29

Involvement of any of the above types of risks make contracts of consideration or exchange

(aqood al muawadat) void with the unanimous opinion of the jurists. In contracts of gifts or

donations (aqood al tabarro‟at), the majority of jurists are of the opinion that these risks make

such forms of contracts void, with the exception of Maliki jurists who view risks in contracts of

gifts are permissible. From this Maliki opinion, contemporary jurists have derived that takaful is

permitted despite containing Risks in Existence, Possession, Quantity and Period.

These risks are deemed excessive and gross in nature as they fall into the categories of gambling

and speculation, being some of the causes for the current global financial crisis. Short sales for

instance are prohibited on the basis they fall foul of the rule on Risk of Possession; they involve

the sale of something (i.e., shares) which are not owned by the seller at the time of the initial

sale. Also, the sale and trading of debt falls foul of the above prohibited categories of risks as

such activities carry with them additional („gross‟) levels of risks, such as the possibility of non-

payment of the debt by the actual debtor.

An important corollary to the prohibition on excessive risk is that shari‟a does not permit a party

to intentionally take on such forms of excessive risks and then to hedge against those same risks

with the help of some form of hedging or risk management tool, irrespective of whether the

actual hedging/risk management tool is shari‟a compliant in itself or not.

3. The third category can be described as a level in between the former two. This can include a

variety of forms of risk, including market risk and operational risk. This is not a risk that is

part of a financing tool‟s inherent structure per se. Therefore, this type of risk can be

mitigated against or avoided.

4.3 Threats posed by risks peculiar to Islamic finance

Insolvency

The threat of insolvency is higher than average due by lack of liquidity in Islamic asset

instruments and securities due to an under developed secondary markets and lack of access to

central bank as lender of last resort in case of a run by investment account holders on the

Islamic Financial Institution. This happens because of the mismatch of maturity term between

Investment account deposits and the longer term financing arrangements. Also most

instruments are held to maturity due to prohibition on sale of debt other than at par, so when

there is a short-term liquidity crunch its effects are more severe unless its owners have funds

elsewhere to provide liquidity, which the usual response is to withdraw from other markets

causing a domino effect.

30

Reputational Damage to the Islamic Finance Brand/Segment

Due to the fragmented nature of Sharia decisions and decrees, which are developed

independently by scholars in different markets, without having judicial precedence

requirements, with some scholars from different schools of thought being more liberal than

other, widespread acceptance is difficult, especially for controversial issues. This prevents an

orderly development of standards of product development and financial reporting. A point to

note is that IFI‟s are required to confirm to the financial reporting framework of its country of

operation. A general fatwa by prominent scholar not on a particular IFI‟s Sharia board can

cause loss of credibility and confidence by the consumers if he makes a compelling argument in

public about a particular transaction or product developed and IFI and approved by its Sharia

board. This is a controversial issue for Islamic Credit card issuers (fixed fee based) and process

on changing underlying security for a sukuk or project funding transaction in the event of real

estate project consolidation on the crash in real estate market. This is compounded by lack of a

universally accepted body for determining mandatory product standards and financial reporting,

plus membership of AAOIF and IFSB is voluntary. In short the risk borne by an IFI is product

is approved by its Sharia board, but vocally disapproved by a leading scholar, causing a

reputational disaster in the perception of the public, aggravated if the scholar was a dissenting

former member of the Sharia advisory board.

Greater potential for volatility of reported earnings

IFI‟s financial statements if prepared and compliant with International Financial Reporting

Standards (IFRS) have to report financial instruments and assets using “mark to market”

principles, due to the requirement of ownership of assets which have to be reported on the

balance sheet and movement in value passing through the income statement, caused profits to

fluctuate more than conventional financial institutions. This aggravates during economic

downturn, as not only are the financial instruments subject to downward valuation, also losses

on assets which will eventually be sold to counterparties.

Operational Risk - Contracts

Islamic Finance transactions are subject to multiple contracts to make them compliant with

Sharia rules, the threat of misclassification of a transaction can lead to a requirement for

different type of contract which if missed would negate the entire transaction i.e. making it non-

Sharia compliant. This is further compounded by lack suitable trained finance personnel in

Sharia Law and Sharia scholars suitably trained in finance to structure Islamic Financial

transactions appropriately.

31

4.4 How to deal with the risks identified

Insolvency

Insolvency caused by lack of liquidity in Islamic Financial Instruments and Sharia non-

compliance of short-term funding from lender of last resort (Central Bank) could be solved by

forming a supra-national body to bailout Islamic Financial Institution‟s funded by a voluntary

donation each year say 0.2% of the member institution‟s operating profits. This fund could also

be used to buy illiquid instruments from IFI‟s to finance short-term liquidity constraints, give

Qardan Hasanah (interest free good loan) to IFI‟s for their short –term liquidity needs, and

operated on a mutual assistance basis. It could also act as manager of last resort to protect

investment account holder‟s funds in case of eminent collapse of a member IFI. This measure

would have a positive impact on the credibility of the Islamic Finance market and improve its

reputation. Qardan Hassanah mentioned in The Holy Quran 'If you lend unto Allah Qardan

Hasanah , He will multiply it for you and He will forgive you, for Allah is the Most

Appreciative , Most Forbearing' (Verse 64-17)

Reputational Damage to the Islamic Finance Brand/Segment

A supra-national co-ordinating body (possibly formed by the merger of AAOIFI and IFSB with

unification of standards) which operates a global database of Islamic Financial products

approved by validly constituted Sharia advisory boards, irrespective of national, sectarian or

doctrinal bias, preferable based in a neutral International Financial Centre like London. This

body could also have a depository of experts on Islamic Law and Finance which could review

products developed which have been challenged by other scholars and considered acceptable by

others by giving an independent opinion (a form of judicial review). Financial reporting for

IFI‟s could benefit if the industry would petition the International Accounting Standards Board

(IASB) to consider issuing an International Financial Reporting Standard (IFRS) for IFI‟s.

Operational Risk – Contracts

This risk can be dealt with by having well reputed scholars on Sharia boards with persons with

knowledge of both Islamic Law and Financial knowledge and belonging to multiple schools of

thought or Islamic jurisprudence, to enable a diversified meaningful debate, when considering

Islamic Products. Furthermore more personnel working within IFI should be encouraged to be

certified by globally reputed Institutions like the Chartered Institute of Management

Accountant‟s17

Certificate in Islamic Finance qualification.

17

http://www.cimaglobal.com/Study-with-us/Certificate-in-Islamic-Finance/

32

4.5 Islamic Financial Instruments/Transactions – Risk Mitigation and Risk Creation

Sukuk (Sharia compliant bond equivalents) and Ijara (lease or buy and rent contracts)

Islamic Financial Institutions that either issue or purchase Sukuk or enter into Ijara contracts are

investing in real assets. The return on these assets takes the form of rent, and is uniformly

spread over the rental period. The underlying asset provides additional security for the investor

and the productivity of the asset is the basis of the return on investment. The claim embodied in

Sukuk is not simply a claim to cash flow but an ownership claim. Hence, interest risk is

avoided and so is the risk of the fluctuation of the value of the borrowing (as selling of debt at a

price other than at par is forbidden), which mitigates the financial risk of the entity. However

the ownership claim has to be reflected in the balance sheet of the IFI which results in volatility

of earnings and balance sheet values due to mark to market rules required for most financial

reporting frameworks. Furthermore, the prohibition of the sale of debt other than at par,

prevents the development of the secondary market in these securities, creating liquidity

constraints as these are not easily convertible to cash.

Musharaka and Mudaraba

Under these transactions the Islamic Financial Institution participates in the profit or loss of the

transaction, instead of receiving interest. These transactions even though compliant with Sharia

create above average credit risk, as a known amount of cash flow in form of interest is replaced

by an uncertain amount of profit or loss.

Derivatives Instruments in Islamic Finance

This is one area which has the most controversy in Islamic Finance, as some of the hadith‟s

used to justify derivative contracts like futures, options and forwards are challenged by many

scholars, plus the lack of understanding of the workings of these instruments among Sharia

scholars and the larger public. However, this dissertation would like to take the view that it is

only a matter of time and financial education of Sharia scholars in the working of derivatives to

hedge against market risks faced by IFI‟s like currency risk and commodity risk, that Sharia

compliant products will gain widespread use. The main argument against derivatives are that it

has excessive uncertainity (Gharar) and is gambling (Maysir). A comment in support of

development of Islamic derivative products by a scholar is stated - "we should realize that even

in the modern degenerated form of futures trading, some of the underlying basics concepts as

well as some of the conditions for such trading are exactly the same as were laid down by the

Prophet Mohamed (PBUH) for forward trading. For example, there are clear sayings of the

Prophet Mohamed (PBUH) that he who makes a Salaf (forward trade) should do that for a

33

specific quantity, specific weight and for a specified period of time. This is something that

contemporary futures trading pays particular attention to." (Fahim Khan, 1996) 18

A recent development in Iran is to allow trading Islamic Derivative products.

The Securities and Exchange Organization of Iran has put on agenda to add new Islamic

instruments such as Derivative Securities, Istisna & Murabaha in Capital Market as of the next

Iranian calendar year (March 21, 2011).19

(Ali Salehabadi, Iran Daily 8th

March 2011)

4.6 Summary

It is well understood that Risk Management is Integral for Islamic Financial institutions, which

is supported by both statements in the Holy Quran and traditions of the Prophet Mohamed

(PBUH). It has been seen that Islamic financial transactions are interest (Riba) free, abhors

uncertainty (Gharar), and eschews gambling (Maysir), however these are not risk free. Islamic

Financial Instruments mitigate against certain risks, while creating others for Islamic Financial

Institutions.

The effect of the recent global financial crises on Islamic Financial Institutions has been

minimal, some commentators have tried to portray this as the superiority of the Islamic

economic system which eschews uncertainty, interest and gambling. This is because one of the

key causes was complex derivative products like credit default swap (CDS) and collateralised

debt obligations (CDO) which very few people understood how they operate and the risks

inbuilt in these instruments. While it is agreed that Islamic Financial Institutions would have

avoided these instruments, however some Islamic Financial Institutions For example, a number

of renowned players in the management of Islamic funds, such as The Investment Dar (TID)

and Global Investment House (GIH), both based in Kuwait, have suffered major losses during

the crisis and have become technically insolvent. Plus the debt crises of Dubai and its

consequent real estate market crash revealed excessive speculation. Hence, a majority of Islamic

Financial Institutions while relatively immune because they were not in the centres where the

financial markets were sophisticated. Furthermore, the experience of Kuwait Finance House

during the Souk Al Manakh20

, is a signal for Islamic Financial Institutions to be vigilant about

risk management, as being Islamic will not protect them from excessive speculation.

18

Fahim Khan (Islamic Futures and their Markets, Research Paper No.32, Islamic Research and Training Institute,

Islamic Development Bank, Jeddah, Saudi Arabia, 1996, p.12)

19 http://www.sukuk.me/news/articles/28/Irans-Bourse-to-Add-New-Islamic-Financial-Instrum.html (21 March 2011

20

http://en.wikipedia.org/wiki/Souk_Al-Manakh_stock_market_crash (accessed 25 March 2011)

34

Chapter 5: Analysis of Risk Management disclosures in Financial Statements

5.1 Introduction

This chapter will look at disclosed information on Risk Management in the published financial

statements of three Islamic Financial institutions namely:-

Meezan Bank (Pakistan)

Khaleej Takaful (UAE)

Al Baraka Banking group (Kingdom of Bahrain)

Disclosures on risk management made in the financial statements will be analysed in reference

to figure 2.2 Key Drivers of Risk in Chapter 2.

5.2 Meezan Bank (Pakistan) - based on the Annual Report 2009

Meezan bank is a Pakistan based bank offering retail, corporate and investment banking

services i.e. savings products, Investment products, credit cards, trade finance, capital raising

(Sukuk) for corporate clients and the Government of Pakistan. The products are similar to those

offered by conventional banks.

Risk Management Framework (Annual Report 2009 - Operations review & Note 40)

“Risk management is an integral part of the business activities of the Bank. The Bank manages

the risks through a framework of risk management policies and procedures, organizational

structure and risk measurement and monitoring mechanism that are closely aligned with the

overall operations of the Bank. Risk management activities broadly take place at different

hierarchy levels. The Board of Directors provides overall risk management supervision while

the management of the Bank actively ensures that the risks are adequately identified, measured

and managed. An independent and dedicated Risk Management department guided by a prudent

and a robust framework of risk management policies and guidelines is in place.

The Board has constituted the following committees for effective management of risks

comprising of the Board members: 1. Risk Management Committee

2. Audit Committee

The Risk Management Committee is responsible for reviewing and guiding risk policies and

procedures and control over risk management. The Audit Committee - comprised of three non-

executive directors - monitors compliance with the best practices of the Code of Corporate

Governance and determines appropriate measures to safeguard the Bank's assets.

The Board has delegated the authority to monitor and manage different risks to the specialized

committees at management level. These committees are comprised of senior management team

members with relevant experience and expertise, who meet regularly to deliberate on the

35

matters pertaining to various risk exposures under their respective supervision. Such committees

include: 1. Credit Committee

2. Asset Liability Management Committee (ALCO)

The Credit Committee is responsible for approving, monitoring and ensuring that financial

transactions are within the acceptable risk rating criteria. Well defined policies, procedures and

manuals are in place and authorities have been appropriately delegated to ensure credit quality,

proper risk-reward trade off, industry diversification, adequate credit documentation and

periodic credit reviews.

ALCO is responsible for reviewing and recommending all market risk and liquidity risk policies

and ensuring that sound risk measurement systems are established and comply with internal and

regulatory requirements. The Bank applies Stress Testing and Value at Risk (VaR) techniques

as market risk management tools. Contingency Funding Plan for managing liquidity crisis is in

place. Liquidity management is done through cash flow matching, investment in commodity

murabaha, Sukuks and placements in foreign exchange. Treasury Middle Office monitors and

ensures that banks exposures are in line with the prescribed limits. The Bank ensures that the

key operational risks are measured and managed in a timely and effective manner through

enhanced operational risk awareness, segregation of duties, dual checks and improving early

warning signals. The Bank has developed effective manuals and procedures necessary for the

mitigation of operational risk. The Bank has an Internal Audit department that reports directly to

the Audit Committee of the Board. Internal Audit independently reviews various functional

areas of the Bank to identify control weaknesses and implementation of internal and regulatory

standards. The Compliance department ensures that all directives and guidelines issued by the

State Bank of Pakistan are being complied with in order to manage compliance and operational

risks. The Internal Controls and Operational Risk Management Committee ensures adequate

internal controls and systems are in place thereby ensuring operating efficiency.

The Board has constituted a full functional audit committee. The audit committee works to

ensure that the best practices of the Code of Corporate Governance are being complied by the

Bank and that the policies and procedures are being complied with. The Bank‟s risk

management, compliance, internal audit and legal departments support the risk management

function. The role of the risk management department is to quantify the risk and ensure the

quality and integrity of the Bank‟s risk-related data. The compliance department ensures that all

the directives and guidelines issued by SBP are being complied with in order to mitigate the

compliance and operational risks. Internal audit department reviews the compliance of internal

control procedures with internal and regulatory standards.

36

RISK MANAGEMENT (Note 40)

The wide variety of the Bank‟s business activities require the Bank to identify, measure,

aggregate and manage risks effectively which are constantly evolving as the business activities

change in response to credit, market, product and other developments. The Bank manages the

risk through a framework of risk management, policies and principles, organisational structures

and risk measurement and monitoring processes that are closely aligned with the business

activities of the Bank.

40.1 Credit risk

The Bank manages credit risk by effective credit appraisal mechanism, approving and reviewing

authorities, limit structures, internal credit risk rating system, collateral management and post

disbursement monitoring so as to ensure prudent financing

activities and sound financing portfolio under the umbrella of a comprehensive Credit Policy

approved by the Board of Directors. The Bank also ensures to diversify its portfolio into

different business segments, products and sectors. Bank take into account the risk mitigating

effect of the eligible collaterals for the calculation of capital requirement for credit risk. Use

of credit risk mitigation (CRM) resulted in the total credit risk weighted amount of Rs.

58,863.71 million whereas in the absence of benefit of CRM this amount would have been Rs.

61,883.49 million. Thus, use of CRM resulted in improved capital adequacy ratio of the Bank

from 12.25% (without CRM) to 12.77% (with CRM).

40.1.2 Credit Risk - General Disclosures Basel II Specific

The Bank is operating under standardised approach of Basel II for credit risk. As such risk

weights for the credit risk related assets (on-balance sheet and off-balance sheet-market and non

market related exposures) are assigned on the basis of standardised approach.

The Bank is committed to further strengthen its risk management framework that shall enable

the Bank to move ahead for adopting Foundation IRB approach of Basel II; meanwhile none of

our assets class is subject to the foundation IRB or advanced IRB approaches.

40.2 Equity position risk in the banking book-Basel II Specific

The Bank makes investment in variety of products/instruments mainly for the following

objectives;

- Investment for supporting business activities of the bank and generating revenue in short term

or relatively short term tenure.

- Strategic Investments which are made with the intention to hold it for a longer term and are

marked as such at the time of investment.

37

Classification of equity investments

Bank classifies its equity investment portfolio in accordance with the directives of SBP as

follows: - Investments - Held for trading

- Investments - Available for sale

- Investments in associates

- Investments in subsidiaries

Some of the above mentioned investments are listed and traded in public through stock

exchanges, while other investments are unlisted.

Policies, valuation and accounting of equity investments

The accounting policies for equity investments are designed and their valuation is carried out

under the provisions and directives of State Bank of Pakistan, Securities and Exchange

Commission of Pakistan and the requirements of approved International Accounting Standards

as applicable in Pakistan. The investments in listed equity securities are stated at the revalued

amount using market rates prevailing on the balance sheet date, while the investment in

unquoted securities are stated at lower of cost or break-up value. The unrealized surplus /

(deficit) arising on revaluation of the held for trading investment portfolio is taken to the profit

and loss account. The surplus / (deficit) arising on revaluation of quoted securities classified as

available for sale is kept in a separate account shown in the balance sheet below equity. The

surplus / (deficit) arising on these securities is taken to the profit and loss account when actually

realised upon disposal. The carrying value of equity investments are assessed at each balance

sheet date for impairment. If the circumstances exist which indicate that the carrying value of

these investments may not be recoverable, the carrying value is written down to its estimated

recoverable amount. The resulting impairment loss is charged to profit and loss account.

Market risk

The Bank is exposed to market risk which is the risk that the value of on and off balance sheet

exposures of the Bank will be adversely affected by movements in market rates or prices such as

benchmark rates, profit rates, foreign exchange rates, equity prices and market conditions

resulting in a loss to earnings and capital. The profit rates and equity price risk consists of two

components each. The general risk describes value changes due to general market movements,

while the specific risk has issuer related causes. The capital charge for market risk has been

calculated by using Standardized Approach. The Bank applies Stress Testing and Value at Risk

(VaR) techniques as risk management tool; Stress testing enables the Bank to estimate changes

in the value of the portfolio, if exposed to various risk factor. VaR quantifies the maximum loss

that might arise due to change in risk factors, if exposure remains unchanged for a given period

of time.

38

40.3.1 Foreign exchange risk

The foreign exchange risk is the risk that the value of a financial instrument will fluctuate due to

the changes in foreign exchange rates. The Bank does not take any currency exposure except to

the extent of statutory net open position prescribed by SBP. Foreign exchange open and

mismatch position are controlled through internal limits and are marked to market on a daily

basis to contain forward exposures.

40.3.2 Equity position risk

Equity position risk is the risk arising from taking long positions, in the trading book, in the

equities and all instruments that exhibit market behaviour similar to equities. Counter parties

limits, as also fixed by SBP, are considered to limit risk concentration. The Bank invests in

those equities which are Shariah compliant as advised by the Shariah adviser.

40.3.3 Yield / Interest Rate Risk in the Banking Book (IRRBB) - Basel II Specific

IRRBB includes all material yield risk positions of the Bank taking into account all relevant

repricing and maturity data. It includes current balances and contractual yield rates. Bank

understands that its financings shall be repriced as per their respective contracts. Regarding

behaviour of non-maturity deposits, the Bank assumes that 75% of those deposits shall fall in

upto one year time frame and remaining 25% of those deposits shall fall in the range of one to

three years time buckets. The Bank estimates changes in the economic value of equity due to

changes in the yield rates on on-balance sheet positions by conducting duration gap analysis. It

also assesses yield rate risk on earnings of the Bank by applying upward and downward shocks.

These IRRBB measurements are done on monthly basis.

40.4 Liquidity risk

Liquidity risk is the risk that the Bank either does not have sufficient financial resources

available to meet its obligations and commitments as they fall due or can fulfil them only at

excessive cost that may affect the Bank‟s income and equity. The Bank seeks to ensure that it

has access to funds at reasonable cost even under adverse conditions, by managing its liquidity

risk across all class of assets and liabilities in accordance with regulatory guidelines and to take

advantage of any lending and investment opportunities as they arise.

39

40.5 Operational risk

The Bank uses Basic Indicator Approach (BIA) for assessing the capital charge for operational

risk. Under BIA the capital charge is calculated by multiplying average positive annual gross

income of the Bank over past three years with 15% as per guidelines issued by SBP under Basel

II. To reduce losses arising from operational risk, the Bank has strengthened its risk

management framework by developing polices, guidelines and manuals. It also includes set up

of fraud and forgery management unit, defining responsibilities of individuals, enhancing

security measures, improving efficiency and effectiveness of operations, outsourcing and

improving quality of human resources through trainings.

Critical Analysis

There is a risk committee at board level and there is a Head of Risk Management as part of

the senior management team. However in Meezan, he does not sit in the board of directors.

It is suggested that “the key to making the enterprise or integrated approach actually happen

is through the appointment of one key individual who takes charge of the whole process and

is given the power at board level to follow through all ideas. Often the person is the Chief

Risk Officer(CRO)” (Merna & Thani 2010)21

The Meezan bank‟s statement on risk management in the operations review and notes to the

financial statements does not disclose its classification risks undertaken by kind of

transaction and type of risk posed, mitigating factors and its response. Although it claims to

have a robust risk management framework, the disclosures are skewed towards financial

risks (probably due to focus by external auditors on quantifiable information) and scant

reference to strategic risks and hazard risks. It would have been interesting to classify risks

in accordance with type of transactions like Sukuk, Islamic Credit card business, Mudaraba,

Ijara, Musharaka etc transactions, how these are mitigated and risks which are retained as

part of the business undertaken.

21

Corporate Risk Management 2nd

Edition Merna and Thani

40

5.3 Al Khaleej Takaful Insurance and Reinsurance Q.S.C.(Qatar)

Al Khaleej is a fully fledged Takaful company offering the full range of insurance products

similar to conventional insurance companies which are Sharia compliant in the State of Qatar.

Risk Management Framework (extracts from Annual Report 2009 Note 25)

The risks faced by the Group and the way these risks are mitigated by management are

summarised below.

Insurance risk

The principal risk the Group faces under insurance contracts is that the actual claims and benefit

payments or the timing thereof, differ from expectations. This is influenced by the frequency of

claims, severity of claims, actual benefits paid and subsequent development of long-term

claims. Therefore, the objective of the Group is to ensure that sufficient reserves are available to

cover these liabilities. The above risk exposure is mitigated by diversification across a large

portfolio of insurance contracts. The variability of risks is also improved by careful selection

and implementation of underwriting strategy guidelines, as well as the use of reinsurance

arrangements.

Reinsurance risk

In common with other insurance companies, in order to minimize financial exposure arising

from large claims, the Group, in the normal course of business, enters into agreements with

other parties for reinsurance purposes. Such reinsurance arrangements provide for greater

diversification of business, allow management to control exposure to potential losses arising

from large risks, and provide additional capacity for growth. A significant portion of the

reinsurance is effected under treaty, facultative and excess-of-loss reinsurance contracts.

To minimize its exposure to significant losses from reinsurer insolvencies, the Group evaluates

the financial condition of its reinsurers and monitors concentrations of credit risk arising from

similar geographic regions, activities or economic characteristics of the reinsurers. Reinsurance

ceded contracts do not relieve the Group from its obligations to policyholders and as a result the

Group remains liable for the portion of outstanding claims reinsured to the extent that the

reinsurer fails to meet the obligations under the reinsurance agreements. The two largest

reinsurer account for 32% of the maximum credit exposure at 31 December 2009 (2008: 45%).

41

Concentration of risks

The Group‟s insurance risk relates to policies written in the State of Qatar only. The segmental

concentration of insurance risk is set out in Note 26.

Sensitivity of changes in assumption The Group does not have any single insurance contract or

a small number of related contracts that cover low frequency, high-severity risks such as

earthquakes, or insurance contracts covering risks for single incidents that expose the Group to

multiple insurance risks. The Group has adequately reinsured for insurance risks that may

involve significant litigation. A 5% change in the average claims ratio will have no material

impact on the consolidated statement of income (2008: same).

Financial risk

The Group‟s principal instruments are available-for-sale investments, receivables arising from

insurance and reinsurance contracts and cash and cash equivalents. The Group does not enter

into derivative transactions. The main risks arising from the Group‟s financial instruments are

interest rate risk, foreign currency risk, market price risk and liquidity risk. The board reviews

and agrees policies for managing each of these risks and they are summarised below:

Regulatory framework risk

Regulators are primarily interested in protecting the rights of the policyholders and monitoring

these rights closely to ensure that the Group is satisfactorily managing affairs for their benefit.

At the same time, the regulators are also interested in ensuring that the Group maintains an

appropriate solvency position to meet unforeseen liabilities arising from economic disasters.

The operations of the Group are also subject to regulatory requirements within the jurisdictions

where it operates. Such regulations not only prescribe approval and monitoring of activities, but

also impose certain restrictive provisions (e.g. capital adequacy) to minimize the risk of default

and insolvency on the part of the insurance companies to meet unforeseen liabilities as these arise.

Foreign currency risk

Foreign currency risk is the risk that the value of a financial instrument will fluctuate due to

changes in foreign exchange rates. Management believes that there is minimal risk of significant

losses due to exchange rate fluctuations and consequently the Group does not hedge its foreign

currency exposure.

Other than balances in United States Dollars, to which the Qatari Riyal is pegged, there is no

significant foreign currency financial asset due in foreign currencies included under reinsurance

balances receivable.

42

Interest rate risk

Interest rate risk arises from the possibility that changes in interest rate will affect future

profitability or the fair value of financial instruments. The Group is exposed to interest rate risk

on certain of its investment securities and deposits. The Group limits interest rate risk by

monitoring changes in interest rates in the currencies in which its cash and interest bearing

investments are denominated.

Credit risk

Credit risk is the risk that one party to a financial instrument will fail to discharge an obligation

and cause the other party to incur a financial loss. For all classes of financial assets held by the

Group, the maximum credit risk exposure to the Group is the carrying value as disclosed in the

consolidated statement of financial position. The Group seeks to limit its credit risk with respect

to customers by monitoring outstanding receivables. Premiums and receivables comprise a large

number of customers mainly within the State of Qatar. Three companies account for 14% of the

receivable arising from insurance contracts as of 31 December 2009 (2008: 26%). Two

reinsurance companies account for 32% of the reinsurance balances receivable as of 31

December 2009 (2008: 45%). The Group manages credit risk on its investments by ensuring

that investments are only made in counter-parties that have a good credit rating. The Group does

not have an internal credit rating of counter-parties and considers all counter-parties to be of the

same credit quality. Unimpaired financial assets are expected, on the basis of past experience, to

be fully recoverable. It is not the practice of the Group to obtain collateral over financial assets

and all are, therefore, unsecured.

Liquidity risk

Liquidity risk is the risk that the Group will not be able to meet its commitments associated with

financial liabilities when they fall due. Liquidity requirements are monitored on regular basis

and management ensures that sufficient liquid funds are available to meet any commitments as

they arise. A significant amount of funds are invested in local quoted securities. The majority of

time deposits held by the Group at the end of the reporting period had original maturity periods

not exceeding one year.

43

Equity price risk

Equity price risk is the risk that the value of a financial instrument will fluctuate as a result of

changes in market prices, whether those changes are caused by factors specific to the individual

security, or its issuer, or factors affecting all securities traded in the market.

The Group‟s equity price risk exposure relates to financial assets whose value will fluctuate as a

result of changes in market prices. The Group limits equity price risk by maintaining a

diversified portfolio and by continuous monitoring of its investments. The majority of the

Group‟s equity investments comprise securities quoted on the Qatar Exchange. A 5% change in

the prices of equities, with all other variables held constant, would impact equity by QR

14,876,376 (2008: QR 14,701,887). There would be no impact on the consolidated statement of

income as all equity Investments are classified as “available for sale”, unless impaired.

Capital management

Capital requirements are set and regulated by the Qatar Commercial Companies‟ Law and Qatar

Exchange. These requirements are put in place to ensure sufficient solvency margins. Further

objectives are set by the Group to maintain a strong credit rating and healthy capital ratios in

order to support its business objectives and maximise shareholders‟ value.

The Group manages its capital requirements by assessing shortfalls between reported and

required capital levels on a regular basis. Adjustments to current capital levels are made in light

of changes in market conditions and risk characteristics of the Group's activities. In order to

maintain or adjust the capital structure, the Group may adjust the amount of dividends to

shareholders or issue capital securities. The Group fully complied with the externally imposed

capital requirements during the reported financial periods and no changes were made to its

objectives, policies and processes from the previous year.

Critical analysis

There is no description of the risk management framework applied to manage risks faced by Al

Khaleej Takaful i.e. whether there is a formal risk management at the operational level, the level

the head of risk management report to or is part of. Part of this lack of disclosure is because

there is no operating review statement as part of the annual report. The note on risk management

simply refers to the management.

A description of the risks faced by Al Khaleej Takaful is given in the notes to the financial

statement, especially financial risk is quite detailed and it describes the business risks of

Insurance and Reinsurance. However it does not delve into strategic risks, operational risk due

to Sharia compliant products and hazard risks and how these are managed, mitigated or retained.

44

5.4 Al Baraka Banking Group (Kingdom of Bahrain- operates in Multiple countries)

Al Baraka Banking Group is a Bahrain incorporated full service bank offering retail, corporate

and investment banking services i.e. savings products, Investment products, credit cards, trade

finance, capital raising (Sukuk) for corporate clients and sovereign governments. It operates

through subsidiaries in the Middle East, North African region, South Africa and South East

Asian countries. Services offered are similar to conventional banks.

Risk Management Framework (extract from Annual Report 2009 Note 25)

“Risk management is an integral part of the Group‟s decision-making process. The management

risk committee and executive committees guide and assist with overall management of the

Group‟s balance sheet risks. The Group manages exposures by setting limits approved by the

Board of Directors. These risks and the processes to mitigate these risks have not significantly

altered from the previous year.

The most important types of risk are liquidity risk, credit risk, market risk and other operational

risk. Market risk includes currency risk, equity price risk and profit rate risk.

a) Liquidity risk

Liquidity risk is the risk that the Group will be unable to meet its payment obligations when

they fall due under normal and stress circumstances. To limit this risk, management has

arranged diversified funding sources, manages assets with liquidity in mind, and monitors

liquidity on regular basis. Each of the Group‟s subsidiaries has a documented and implemented

domestic and foreign currency liquidity policies and procedures appropriate to the nature and

complexity of its business. The policy addresses the subsidiaries‟ goal of protecting financial

strength even for stressful events.

b) Credit risk

Credit risk is the risk that one party to a financial contract will fail to discharge an obligation

and cause the other party to incur a financial loss. The Group controls credit risk by monitoring

credit exposures, and continually assessing the creditworthiness of counterparties. Financing

contracts are mostly secured by the personal guarantees of the individuals who own the

counterparty, by collateral in form of mortgage of the objects financed or other types of tangible

security.

Type of credit risk

Financing contracts mainly comprise Sales (Murabaha) receivables, Salam receivables, Istisna‟a

receivables, Mudaraba financing, Musharaka financing and Ijarah Muntahia Bittamleek.

45

Sales (Murabaha) receivables

The Group finances these transactions through buying a commodity which represents the object

of the murabaha and then resells this commodity to the murabeh (beneficiary) at a profit. The

sale price (cost plus the profit margin) is repaid in instalments by the murabeh over the agreed

period. The transactions are secured at times by the object of the murabaha (in case of real estate

finance) and other times by a total collateral package securing the facilities given to the client.

Salam receivables

Salam is a contract whereby the Group makes an immediate payment to a seller for the future

delivery of a commodity. To protect itself from risk associated with the commodity the Group

simultaneously enters into Parallel Salam contract whereby it sells the commodity for deferred

delivery for immediate payment.

Istisna’a receivables

Istisna‟a is a sale agreement between the Group as the seller and the customer as the ultimate

purchaser whereby the Group undertakes to have manufactured or acquire a goods and sell it to

the customer for an agreed upon price on completion at future date.

Mudaraba financing

The Group enters into mudaraba contracts by investing in funds operated primarily by other

banks and financial institutions for a definite period of time.

Musharaka financing

An agreement between the Group and a customer to contribute to a certain investment

enterprise, whether existing or new, or the ownership of a certain property either permanently or

according to a diminishing arrangement ending up with the acquisition by the customer of the

full ownership. The profit is shared as per the agreement set between both parties while the loss

is shared in proportion to their shares of capital or the enterprise.

Ijarah Muntahia Bittamleek

This is a lease whereby the legal title of the leased asset passes to the lessee at the end of the

Ijarah (lease) term, provided that all Ijarah instalments are settled.

Credit Risk Mitigation

All the Group‟s subsidiaries, with exposures secured by real estate or other collateral carry out

regular and periodic collateral verification and evaluation. This collateral verification and

valuation is conducted by an independent qualified assessor or Collateral Analyst at the

subsidiary. The frequency of such collateral verification is determined as a part of the credit or

46

investment policy and approval process. The Group‟s subsidiaries allow cars, ships, aircraft,

satellites, railcars, and fleets as collateral for a credit and investment product but do not accept

perishable assets or any other assets with depreciable life of less than five years. Subsidiaries do

not accept any assets as collateral if the assets are susceptible for obsolescence in case they are

moved (e.g. furniture). Subsidiaries also ensure that these assets are insured in order to be

accepted as collateral. Third party cheques are accepted as collateral by the Group‟s

subsidiaries. However, they are not eligible collateral for capital adequacy calculation. The

Group‟s subsidiaries accept commercial papers as qualifying collateral if they are issued by

banks or corporations of good credit standing. Since the maturity tenor of the commercial

papers are generally short in nature (maximum of 270 days), they are not accepted as collateral

for long–term facilities (i.e. the financing tenor should not exceed the commercial papers

maturity tenor). The subsidiaries do not accept vehicle or equipments, if new, as qualifying

collateral for more than 80% of its market value. No used vehicles or equipment, are accepted as

qualifying collateral for more than 50% of its insured value.

Collaterals listed hereunder may attract capital relief from capital adequacy requirements as per

the Central Bank of Bahrain‟s stipulations:

1) Hamish Jiddiyyah (HJ) (Good faith deposit): Subsidiaries take this type of collateral in the

transactions for which non-binding promises to perform is given by the customer. If a customer

does not honour his promise to perform, the subsidiary has recourse to the deposit.

2) Third party guarantee: The subsidiary should have recourse to the guarantor in case of

customer‟s default. In order to qualify as eligible collateral, the guarantee should be

unconditional and irrevocable. The guarantor must be solvent and, if applicable of investment

grade rating.

3) Urbon: This is the amount that should be taken from a purchaser or lessee when a contract is

established and it is the first line of defence for the subsidiary if the purchaser or lessee breaches

the contract.

4) Underlying assets of the lease contract: The underlying asset must be of monetary value and

the subsidiary must have legal access to it, own it and sell it to cover the open exposure with the

customers in question. The assets have also to be free of any of any kind of encumbrance. Any

excess amount resulting from the closure of the pledge by the subsidiary should be returned to

the customer (pledgor). The subsidiary should conduct at least annual evaluation of the pledged

assets and keep adequate documentation of this evaluation.

5) Cash deposit free from any legal encumbrance with the subsidiary either in the form of

restricted or unrestricted investment accounts.

47

6) Rated and unrated senior sukook issued by first class financial institutions or by GCC

sovereigns.

Credit Quality

Credit Risk Management at the Group will be based upon the creation and maintenance of a

Credit Rating System (CRS) for the non-retail business i.e. obligors or counterparties with more

than US$663,130 in total credit facilities. All the Group‟s units are to incorporate into their

respective credit policies the CRS as the framework for credit management taking into

consideration the methodology requirements of their local central banks,in this respect. The

methodology for obligor (issuer) rating will reflect the specifics of the Group‟s main business

and the geographical diversity of its operations. Ratings of countries, governments and financial

institutions are carried out in centralised fashion at the Bank in Bahrain whereas rating of

corporates is done at the subsidiaries level, unless the exposure to the corporate involves cross-

border risk, in which case, that rating will also be at the Bank as part of the credit limit

approval.

The CRS at the Bank has also been designed to be comparable to the rating system of major

international rating agencies (Moody‟s, Standard & Poor‟s, Fitch) in respect of their foreign

currency rating of countries, governments and financial institutions. Accordingly, countries,

governments and financial Institutions will be rated on the basis of their unsecured medium

term foreign currency obligations. This means that for governments and financial institutions

the cross-border risk will also be part of the rating and the country‟s rating will be, in most

cases, the ceiling on the financial institution‟s rating. Corporates will be rated on their senior

unsecured medium term local currency obligations, unless the credit granted is across border or

in foreign currency. In the latter case, the obligor‟s country‟s rating will be the ceiling on

corporates‟ rating. Where all credit to a government is in local currency, the rating for that

government is the best i.e. 1 on the rating scale, however, if the exposure to the government

includes foreign currency, the rating for that government will be the same as the country‟s

rating. A rating is a forward looking indication of creditworthiness. It is based on an evaluation

of past performance, present conditions and outlook for the future.

The basic approach of the major credit rating agencies to rating is the same as what the Group

credit policies require i.e. a comprehensive fundamental analysis of all relevant quantitative and

non quantitative factors aimed at identifying actual and potential vulnerability.

Credit rating will be applied to countries and single obligors. Single obligors, in turn are

categorised as financial institutions, corporates, governments and retail. CRS therefore rates

obligors (issuers) and not facilities. The obligor rating of countries and single obligors will

48

identify the relative probability of default but will not take into account the impact of collateral

security and other mitigates in the event of default. Facility ratings by contrast, combine both

the probability of default and loss severity in case of defaults. However, initially the Group wide

policy will be to set up obligor ratings only (which does not prevent individual subsidiaries

internally to also rate facilities if they so wish).

c) Concentration risk

Concentrations arise when a number of counterparties are engaged in similar business activities,

or activities in the same geographic region, or have similar economic features that would cause

their ability to meet contractual obligations to be similarly affected by changes in economic,

political or other conditions. Concentrations indicate the relative sensitivity of the Group‟s

performance to developments affecting a particular industry or geographical location. In order

to avoid excessive concentrations of risk, the Group policies and procedures include specific

guidelines to focus on country and counter party

d) Market risk

Market risk arises from fluctuations in profit rates, equity prices and foreign exchange rates.

Under Market Risk Policies currently implemented, the management of the Group have set

certain limits on the level of risk that may be accepted. This is monitored by the local

management at the subsidiary level.

Profit rate risk

Profit rate risk is the risk that the Group will incur a financial loss as a result of mismatch in the

profit rate on the Group‟s assets and URIA. The profit distribution to URIA is based on profit

sharing agreements. Therefore, the Group is not subject to any significant profit rate risk.

However, the profit sharing agreements will result in displaced commercial risk when the

Group‟s results do not allow the Group to distribute profits inline with the market rates.

Equity price risk

Equity price risk is the risk that the fair values of equities decrease as the result of changes in

the levels of equity indices and the value of individual stocks. The equity price risk exposure

arises from the investment portfolio. The Group manages this risk through diversification of

investments in terms of geographical distribution and industry concentration.

The Group has total equity portfolio of US$ 362,489 thousand (2008: US$ 319,603 thousand)

comprising of available for sale investments amounting to US$ 354,297 thousand (2008: US$

294,403 thousand) and trading securities amounting to US$ 8,192 thousand (2008: US$ 25,200

thousand). Variation of 10% increase or decrease in the portfolio value will not have a

significant impact on the Group‟s net income or equity.

49

Foreign exchange risk

Foreign exchange risk arise from the movement of the rate of exchange over a period of time.

Positions are monitored on a regular basis to ensure positions are maintained within established

approved limits.

Foreign currency risk sensitivity analysis

In order to measure its exposures to currency risk, the Group stress tests its exposures following

the standard shocks adopted by Derivatives Policy Group in this respect which calculates the

effect on assets and income of the Group as a result of appreciation and depreciation in foreign

currencies in relation to the reporting currency of the Group. This is done using various

percentages based upon the judgement of the management of the Group.

e) Operational Risk

Operational risk is defined as the risk of loss resulting from inadequate or failed internal

processes, people and systems or from external events. This definition includes legal risk, but

excludes strategic and reputational risk.

Operational Risk Management Framework

The Group guidelines have the following sections:

(1) Operational Risk Appetite

(2) Operational Risk Management – Structure and Rules,

(3) Risk and Control Assessment

(4) Internal Audit

(5) Operational Risk and Basel II and

(6) Operational Risk Capital Requirement.

The Group‟s Operational Risk Appetite is defined as the level of risk which the Group chooses

to accept in its identified risk categories. Operational risk appetite is expressed in terms of both

impact (direct loss) and the probability of occurrence.

The Operational Risk framework will be subject to periodic Internal Audit.

The Group categorizes operational risk loss events into the following categories:

Infrastructure Risks

Availability of information technology is of paramount importance to the Group‟s

infrastructure. The operations of the Group and the subsidiaries might be disrupted and severe

operational risks could occur and an extreme possibility is the threat of a subsidiary‟s existence.

In order to hedge the subsidiaries from the infrastructure risk as outlined above, every

subsidiary must take all the necessary measures indicated in the Business Continuity Plan and/or

Disaster Recovery Plan (BCP and DRP) to cater for these risks.

50

Information Technology Risks

The main risks that the Group is exposed to in this context is from inadequate software and

hardware quality, unauthorized access by third parties or employees, etc.

Staff risk

The main risks that arises from staff risks are risks due to larceny, fraud, corruption, crime, etc.

In order to prevent these risks from occurring, the Group has established Group Human

Resources Policies and Code of Conduct which entails constructive ways in dealing with

mistakes and frauds. The Group has also established approval control steps in business

processes as well as creating separate internal control processes. Further, the Group has

established measures of organizational structure in terms of segregation of duties as well as

diverse training measures to reduce human errors and frauds, etc.

Business risk

This risk may take on the following forms:

1) Processes without clear definitions, for example, when insufficient time was spent on

documenting or updating the already documented processes.

2) Outdated process descriptions in cases where “reality” already strongly differs from the

guidelines laid down in the past.

3) The extreme case of a completely missing documentation to hedge the risk, the Group adopts

sound documentation policies of business processes as it is a basic requirement for a well

functioning process organization. The process description are up to date and clear; furthermore.

it is made accessible to the employees in as simple way as possible.”

Critical Analysis

There is a board risk committee, however there is no Chief Risk Officer at the board level.

Head of Credit and Risk Management reports to the President and Chief executive, unlike

the head of internal audit who reports to the Audit and governance committee of the board

of directors. Furthermore, considering the scope of operations and size of Al Baraka

banking group the role of head credit and head of risk management should be split.

The group has good disclosures on the type of Islamic Financial transactions undertaken, its

business risks, operational risks and some hazard risks. It could give information on

strategic and reputational risks, however this non-disclosure could be justified on being

sensitive confidential information especially on competitive risks. However industry

structure and reputational risks could be commented on without much damage.

51

5.5 Tabular Comparison based on Key Risk Drivers of Risk of Disclosures

Risks Meezan Bank Al Khaleej

Takaful

Al Baraka Banking

Group

Financial Risks

Foreign Exchange Risk √ √ √

Interest Rate Risk/Profit rate √ √ √

Credit Risks √ √ √

Liquidity and cash flow √ √ √

Operational Risks

Accounting controls √ √ √

Information systems X X √

National Culture and Regulations √ √ √

Hazard Risks

Products and Services X X √

Legal Contracts X √ √

Property destruction X X √

Strategic Risks

Competition X X X

Customer Changes and Demands X X X

Industry Structure Changes X X X

Research and product development X X X

Key

√ Disclosure made

X No disclosure made

52

5.6 Summary

The risk management disclosures are heavily skewed towards financial risks, with Al Baraka

Banking Group being the only one disclosing its transactional risk, operational risks and hazard

risks. This could be attributed to the bias of the preparers of the financial statements and

regulatory reporting framework which does not make these disclosures mandatory.

A lamentable observation is that none of the Islamic Financial Institutions analysed had a Chief

Risk Officer at board level and neither did the Head of Risk report directly to the Board of

Directors or its Board Risk committee. While this is primarily a corporate governance issue

(corporate governance and sound risk management are intertwined) hence, corporate boards

need to be more vigilant and proactive regarding risk issues especially for boards of financial

institutions. This is asserted because one of the leading shortcomings made apparent in the

aftermath of the recent global financial crises was a failure of corporate boards, its advisors,

employed financial professionals and external auditors was not understanding or appreciating

the risks undertaken by the financial institutions. This become even more pertinent if not

understanding the risk was the cause of the failure of an Islamic Financial Institution. IFI‟s

cannot afford to take the view that they are different, which is usually the cause of hubris and

decline.

53

Chapter 6: Analysis of responses from Linkedin Pilot Survey questioner

6.1 Introduction

This chapter will analyse the responses for the pilot survey questioner put forward to groups

related to Islamic Finance namely Islamic banker, Halal research council, Islamic banking and

Finance, Islamic banking professionals, Islamic Finance Consultants, Advisors and Practitioners

(IFCAP) , Islamic Finance Pro, Islamic Finance research and Islamic Investment and Finance

requesting its members to fill in the pilot questioner to elicit their opinion on a number of issues

related to Risk Management in Islamic Financial Institutions. The survey was carried out using

zoomerang see links below:-

Part 1 http://www.zoomerang.com/Survey/WEB22BY64TYG5U

Part 2 http://www.zoomerang.com/Survey/WEB22BY65KYGLH

However, the response rate to the pilot survey was not great as only three (3) responses were

received for part one of the pilot survey, out of seventy nine (79) visits and two (2) responses

for part two of the pilot survey out of eighty seven (87) visits. Hence, all responses will be

tabulated, as although the opinions will not be statistically valid but these provide qualitative

insights into risk management practices in Islamic Financial Institutions. The author would like

to speculate that the reason for the poor response was due to the fear of giving out confidential

information rather than cover up weak risk management practices in Islamic Financial

Institutions.

54

6.2 Questions and responses to part one of the survey

Questions Response 1 Response 2 Response 3

1 Is there a formal process of

recording potential risks, if

so describe?

No A specialized Risk

Management

Department is tasked

with this function.

Incident report at

branch level for

tracking risk

undertaken

2 Who is responsible for

tracking risks undertaken by

the IFI (CRO, FD, CEO, CFO)?

The board and FD Chief Risk Officer Risk and

compliance dept

based in head office

3 Are risk specific to a

individual major transactions

separately identified, if so

how are they added to the

risk profile on the IFI

Identified but no

system to

incorporate it into

corporate risk

profile

Policies and

guidelines have been

formulated for risk-

related activities,

Risk Management

and Internal Audit

ensures compliance.

Yes and they are

added to the risk

profile

4 How are potential risks

identified in the IFI you are

familiar with?

By external

auditors who do

risk assessment as

part of annual

audit.

Transaction risk

profile is included in

every major

transaction and Chief

Risk Officer is

present in Credit

Committee meetings.

It is a collective

responsibilities of

all staff at their

different levels

5 How are the implications of

the risks identified

quantified?

Not known Reporting systems

are in place to track

exposure levels.

They are quantified

as either

manageable or

disastrous.

6 Are risks quantified in

accordance with how often

they occur?

Not known Risk Management

Committee monitors

key indicators

regularly.

Yes

55

6.2 Questions and responses in part one of the survey (continued)

Questions Response 1 Response 2 Response 3

7 Are risks quantified as to

severity i.e. potential of

loss or impact on IFI?

Not known As Above, reports are

automatically generated to

determine value at risk.

Yes

8 To whom are these reported

i.e. to the Board of directors

or executive management?

The annual risk

assessment by

external auditors is

reported to the

board

Management members sit

on Risk Management/

Asset Liability Committee

reporting to the Board.

Board of

Directors

9 The following are the

typical responses to

minimize risk for an entity,

please indicate in your

opinion the percentage of

occurrences the particular

response is chosen? Total

100% Risk Avoidance,

Risk reduction, Risk

transfer. Risk retention.

Risk Avoidance

10% Risk reduction

50% Risk transfer

10% Risk

Retention 30

Risk Avoidance 50% Risk

Reduction 10% Risk

Transfer 2% Risk

Retention 38%

No Answer

10 How is the desirable/

acceptable level of risk

determined and who

determines this level?

The board of

directors

Policies and Guidelines

are approved by the Board

of Directors

The risk dept

determines the

level of risk

11 How are resources

allocated to ensure the

overall risk level is

acceptable?

By Board with

consultation of

CEO and CFO

Risk Management systems

go across the board from

management to managers to

IT systems.

No Answer

12 Are contingency plans put

place should the risk

materialize?

Not aware It is included in the

Policies and Guidelines.

Yes

56

Commentary/Critical Synthesis

There has been no mention of the existence of a corporate risk register, while a branch level

incident report or the Risk and compliance or Risk and Credit department could be

maintaining a register, this is not very clear. Neither is it clear who at branch level co-

ordinates risk to ensure the head office incorporates branch level transactional risks.

There is a systematic quantification of risk using software calculating value at risk at regular

intervals, this though commendable, needs to be understood and professional judgements

made at board level (that where the buck stops), which should have a risk professional to

ensure fellow board members can understand the implications. There appears to be a

tendency to group risk management, with credit, internal audit, finance, compliance

functions, while they have overlaps, they are separate functions on their own. IFI‟s with

their unique types of risks should endeavour to segregate the functions.

6.3 Questions and responses on part two of the survey

Question Response 1 Response 2

1 How are contingency plans communicated to

the members of the organization responsible

for action should the envisioned risks

materialize?

Not known Not known

2 In your opinion is the state of risk

management practice adequate for the needs

of the IFI, you are familiar with?

No in my honest opinion. No.

3 In your view what are the three key

improvements that should be made to make

the risk management process better?

A Chief Risk Officer

should be appointed. An

Enterprise Risk

Management approach be

undertaken. Improvement

in communication to

parties concerned about

risk and how deal specific

data can be incorporated.

Staff conversant

with both finance

and Sharia. Have a

Risk management

department with

head of Risk at or

reporting at board

level.

57

The following are the Global Top 10 risks as Identified in The Ernst & Young Business Risk Report

2010 (2009 rank in brackets), please rank the risks in your opinion as they apply to Islamic

Financial Institutions:

NB: Rank 1 & 2 refer to ranking by respondent 1 and 2 Rank 1 Rank 2

1 Regulation and compliance (2) 2 2

2 Access to credit/funding (1) 1 1

3 Slow recovery or double-dip recession (No change) 4 6

4 Managing talent (7) 3 3

5 Emerging markets (12) 5 4

6 Cost cutting (No change) 6 7

7 Non-traditional entrants (5) 7 8

8 Radical greening (4) 10 None

9 Social acceptance risk and corporate social responsibility (New) 9 5

10 Executing alliances and transactions (8) 8 None

Commentary/Critical Synthesis

From the responses it appears that communication of risk information is lacking, although

everyone to a varying degree is responsible for managing risk this is an area for

improvement. And risk management should be institutionalised in IFI‟s at all levels.

The top risks even though in different order remain Access to credit/funding, regulation and

compliance and managing talent. In the authors view social acceptance and corporate social

responsibility should have been ranked higher for IFI‟s as the social mandate of Islamic

economics is wider, plus reputational risk which is closely linked to social acceptance is at

stake due to the value system it embraces and promotes.

58

6.4 Summary

There appears to be a risk management department in place, in line with most financial

institutions. It appears from the findings that risk management although present in different

form‟s in Islamic Financial institutions, it is not adequate. Using the analogy of the parable of

the ladder, “A person being told by friends to buy a ladder, so if his roof leaks, can go up and

fix it, he goes to the store gets a ladder for eight (8) feet, so now when asked by friends whether

he has a ladder he says yes. After some heavy rain his roof leaks, he takes out his ladder puts it

on the wall to climb to the roof, he realises that it needed a twelve (12) feet ladder. ”

One of the key factors supporting this view is the lack of communication, on the exact

processes, it is assumed that having a Head of risk management and a risk management

department takes care of all matters related to risk management. The other key issue is risk

management is bundled with credit department which is an operational role, with a common

head for Risk and Credit functions, hence the head of risk usually reports to Executive

management i.e. does not have board level representation like the finance function nor direct

board level reporting like internal audit. This situation is not satisfactory as it was observed in

the aftermath of the recent global financial crises, executive management excesses can cause

seemingly robust systems fail, Islamic Financial Institutions would be no exception to this

human tendency. I would suggest either the Chief Risk Officer have a board seat or he reports

directly to the board/board risk committee.

The risk management practices and tools used are modelled on conventional financial

institutions, such as credit committees, asset and liability committee, risk committee at the

board level and use on value at risk measures, branch level incident registers etc. The risk

profile of Islamic financial institutions are similar to conventional financial institutions, with

differing emphasis on some issues like risk related to transactional contracts and compliance are

higher in IFI, as they not only have to comply with the regulatory framework which all financial

institutions in a country comply, but also they have to comply with rules specific to Islamic

jurisprudence.

However, it appears that the Sharia advisory board which is a key element in the governance

structure of an Islamic Financial Institution especially related to product and transaction

approval to ensure that it conforms to the tenets of the Islamic faith and jurisprudence doctrines

of Sharia, is not directly involved with risk management. In the authors view as most products

and transactions undertaken by IFI are similar to those in conventional finance but become

59

legitimate in Sharia due to a series of contracts, which comply with Islamic economic principles

to enable the IFI to earn and profit and distribute the profit to its investors and owners, the

Sharia advisory board should have a part to play in risk management. The product and

transaction approval process to ensure compliance with Sharia, also has risks especially

reputational risk, should an approved transaction be later proven to not to be compliant with

Sharia, due to a small error of omission or commission in a contact. In this case the entire profit

has to be forfeited to charity plus loss of reputation. Hence product and transaction risk is high

due to adherence to Sharia requirements, therefore the Sharia advisory board has to have a role

in risk management and the head of risk should regularly brief them.

60

Chapter 7: Conclusions and Recommendations for Further Work

7.1 Review of the Dissertation

The first chapter is on the objectives of the research, methodology, research questions which

would be asked of respondent, the scope and limitations of the dissertation.

The second chapter is on the function of risk management its definitions and purposes. It also

gives an overview of the tools and techniques used in the practice of risk management, the risk

management process, types of risks in Islamic Financial Institutions and the key drivers of risk

in any organisation.

The third chapter looks at the concept of Islamic Finance, which is based on the Islamic

economic model and it is based on Sharia - Islamic jurisprudence and its various schools of

thought. The Islamic Finance model is based on the prohibition on interest (riba), uncertainty

(gharar) and gambling (maysir). It takes a brief look at the products or type of permissible

contracts which form the cornerstone of Islamic Financial products including Takaful. It then

does a brief comparison of a conventional bond with a Sukuk and Insurance with Takaful.

The fourth chapter is on the importance of Risk Management in Islamic Financial institutions

and the basis for it in Sharia, sourced from the Quran and traditions of Prophet Mohamed

(PBUH). It further looks into risk classification in accordance with classical Islamic law, the

risks created by adherence to Islamic law, with a view to assert that Islamic Finance is not risk

free even though it strives to avoid interest, uncertainity and gambling/excessive speculation as

in conventional finance, the risks are simply different and need to be managed.

The fifth chapter present an analysis of public disclosures in the financial statements of three

different Islamic Financial Institutions one an Islamic bank operating in the Islamic Republic of

Pakistan, the second an Islamic Insurance (Takaful) operating in the State of Qatar and the last

one a Bahrain based Islamic banking group operating in mainly Muslim majority nations in

Asia and Africa. These disclosures were then compared against a risk framework.

The sixth chapter is on the pilot research survey on risk management practices in Islamic

Financial institutions and elicit opinion of practitioners on the way forward. The survey had the

expectations that in addition to the risk management practices and metrics used by conventional

financial institutions would be applied to Islamic Financial Institutions in this respect the

expectations were met. However the survey failed to identify risk management practices to

mitigate the unique risks inherent in the Islamic economic mode, use of alternative risk

management tools (derivatives prohibited) to hedge against currency risk and the contractual

risk of a series of contracts in nearly every transaction should have been addressed qualitatively.

61

Other noteworthy findings in the second part of the survey included:-

Some of the respondents, in their opinion considered risk management practices in the

institutions they are familiar with not to be adequate. This could be due to lack of

knowledge of what the risk management department in head offices actually do, so there is a

likely hood of a communication gap, which needs to be addressed as the first line of defence

to manage risk is the rank and file employee. On the positive this means professionals in

IFI‟s do know there is room for improvement and are not complacent.

The top ranked risk was lack of funding/credit, hence this debunks the notion that the oil

and gas money from the Middle East, has made IFI‟s awash with liquidity.

7.3 Conclusions

Islamic Finance is growing at a phenomenal rate relative to conventional finance due to its

ethical principles which are enshrined also in the Holy Bible and Holy Torah, hence it is getting

acceptance worldwide. However, the practice of risk management in Islamic Finance has not

kept pace. The beauty of Islamic Finance is in its partnering approach, mutual assistance and

taking a long term view to its relationships with its investors and customers.

The key finding was strategic risks and to an extent operating risk due to the nature of contracts,

in Islamic Financial Institutions is neglected to be disclosed to the users of the financial

statements. Reputational risk which is tied to social acceptance was not commented on in the

financial statements as approved transactions by an institutions Sharia Advisory Board could be

deemed to be prohibited by other influential Islamic scholars and jurists. This risk is very high

due to the heterogeneous nature of the sources of Islamic Law. Islamic Financial Institutions

need to address the issue of involving the Sharia Advisory board in its risk management process

to ensure risks associated with Sharia compliance are adequately addressed and contingency

plans made should there be a reputational fallout anytime in the future on a product or

transaction.

The key findings for improvement were that even though risk management was addressed at the

board level by having a risk management committee and a head of risk, this function was

attached to credit and lending, compliance and internal audit and reported to executive

management, not to the board committee on risk or the full board. The other finding was that no

mention was made about the role, if any, the Sharia advisory board plays in the risk

management nor of them being briefed on risk management practices. The author would

consider the Sharia Advisory Board as a key component of corporate governance for an Islamic

62

Financial Institution, who approve products and transactions which are a source of risk, should

be involved in risk management. This potential neglect could be attributed to talent

management i.e. lack of suitably trained Sharia scholars with an appreciation of risk

management and professional risk managers with an appreciation of Sharia Law. The other

major issue to address is that of talent (skills) management i.e. have trained people in risk

management, finance and Islamic jurisprudence. Related to this is the segregation of risk

management from operational functions like credit and asset liability management.

The author would like to conclude that risk management in Islamic Financial Institutions is

modelled on risk management practices in conventional financial institutions, which is

commendable but not adequate to address the unique risks created by Islamic transactions.

Hence the recommendation for improvements i.e. way forward should be as follows:-

Greater involvement of the Sharia Advisory Board in the risk management process, who

should be briefing the risk management department on the risks posed by transactions and

products approved, especially the Sharia Law technical parts.

Training of personnel in risk management, Islamic Finance and Sharia with courses from

reputed institutes the Chartered Institute of Management Accountants, and employ people

working in the risk management function to have the Financial Risk Manager designation.

Head to risk management function (Chief Risk Officer) to be allocated a seat in the

boardroom or at a minimum direct reporting to the board or the board committee and be

separated from operational functions like credit, asset and liabilities, which might

compromise their objectivity.

Set up a globally co-ordinating board to be a depository of all approved products and be

manned by scholars from all schools of thought, who would validate Islamic finance

products which comply with recognised Islamic schools of thought. They could also act as

arbitrators in case of disputes and set mandatory standards to be follow by any Institution

styling itself as selling Sharia compliant products. It could also play liaison role to have an

International Financial Reporting Standard issued on Islamic Finance by the International

Accounting Standards Board. This could be formed by the merger of AAOIFI and IFSB.

Use of Islamic Sharia compliant derivatives (to be developed by Islamic Finance

professionals with the help of Sharia scholars) to hedge against currency risks and other

risks where conventional finance has derivatives .

63

A supra-national fund be set-up where member Islamic Financial Institution‟s contribute a

percentage of their profits to act as a “lender of last resort”, to assist member organisation

having short term cash flow problems by buying their illiquid securities, it could also

extend Qardan Hassanah to members who are about to fail i.e. like a deposit protection fund

and provide temporary management services to these institutions. This would signal to the

global finance market that the Islamic Finance market is secure.

7.3 Recommendations for further Work

This dissertation looks at the risk management function in Islamic Financial Institution,

however further work is recommended on the interplay between risk management and corporate

governance (both Board of Directors and Sharia Advisory Board) in Islamic Financial

Institutions. Furthermore, the involvement of the Sharia advisory board in the risk management

process needs to be studied and their potential inputs to the enterprise wide risk management

function should be considered. Further research work need to be carried out from inside the risk

management function at head office and board level to evaluate the degree of emphasis on risk

management in particular organizations. Lastly the role that Islamic jurisprudence compliant

derivative products could play in reducing risk in Islamic Financial Institutions could be

researched.

64

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