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