risk management for islamic financial institutions - by elias aby alhaija - icompetences ifc2012

7/29/2019 Risk Management for Islamic Financial Institutions - By Elias Aby Alhaija - iCompetences IFC2012

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The IFC Conference Islamic Finance: Myths,

Realities, and Best Practices

27& 28 /12/2012

Marrakech/ Morocco



Risk Management of Islamic Banking

Dr. Elias Abu AL-Haija Ass. Professor ECT, UAE



1) Concept of Risk Management.

2) An overview of the Basel.

3) Islamic Bank Risk identification.

4) Concept of Risk management in Islam.

5) Islamic Banking and Operational Risk.

E-mail: [email protected] Mobile+ 971 5 2842846

The Agenda



Concept of Risk Management




E-mail: [email protected] Mobile +971 5 2842846

There is always the likelihood that:• A Car bumps into your car.• You hit a pedestrian.

• You bump into another car.• You simply crash.

• Etc.Some car accidents are of low

frequency of occurrence, but withhigh impact.

There are always concerns over:• The quality of the road you are

driving on.

• The quality of your brakes.• The quality (i.e., reliability) of

your car.• The quality of the cars driving

around you

• Your state of mind.• The pedestrians on the streets.

• Etc. . . .The more of these concerns

you can manage, the less likely you will have to worry aboutpotential losses

Risks

Results

- Buy Insurance

- Put your Seat-Belt on

- More frequent Inspections

- Others (Don’t Buy Insurance)

Risk Management for the average person on the streets(A Car Driver/Owner)

Controls Risk Management

- Don’t go on the streets!

Risk s




The stories and worries are no different

here!

Risk Managementis understanding

what caused theaccident.

Take the properactions to prevent

it from happening

again,

Minimize the loss if

a n d w h e n i thappens again!


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Risk Management: keep the cat away from the dogs!



Once upon a time flying was side-ways; and planes parked right on the tipof their wings! High Impact – Low Frequency (to the extent of being very rare!)



Which one of these animals would you select to take careof for a day with in a 50m2 room; and alone? (“No Selection” isnot an option you may exercise!)

1 2 3

4 5 6

Is Risk Management an argument in yourdecision-making process?

Risk is to be managed not feared! Decisions must be based on facts, asufficient understanding of the environment, . . . Definitely, it must not be

based on fears!



“Risks”

Shall Not Be Feared!




It is more than compliance – it is about building value byoptimizing, rather than minimizing risks

Risk management is not about avoiding risk. It helps yoube aware of the risks inherent in your business (Actions)and take advantage of this knowledge to gaincompetitive advantage and enhance shareholder value(Improve the quality of your life).

Valuecreates

shareholderwealth

Risk createsopportunity

Opportunitycreates

value

Risk Management Philosophy



Yes Complex, but hiding your head in the sandis not going to solve your problem!

Risk Shall beManaged

Not Feared!



An Overview of the Basle I&II




The Original Basle Agreement

" In 1986, U.S. bank regulators proposed that U.S.banks be required to maintain capital that reflects therisk of bank assets.

"By 1988, the proposal had grown to include risk-based capital standards for banks in 12 industrializednations according to the terms of the Basle

Agreement.

" Regulations were fully in place by the end of 1992.




Risk-based elements of the plan in Old Accord

" According to the accord, to determineminimum capital requirements, bank managers follow a four-step process:1. Classify assets into one of four risk categories;2. Classify off-balance sheet commitments and

guarantees into the appropriate risk categories;3. Multiply the dollar amount of assets in each risk

category by the appropriate risk weight; thise q u a l s r i s k - w e i g h t e d a s s e t s ; a nd4. Multiply risk-weighted assets by the minimum

capital percentages, currently either 4 percent or 8p e r c e n t .




The original Basel Accord’s approach to capital

requirements was primarily based on credit risk.

" Although it set appropriate protections from amarket- and credit-risk perspective, it did not addressoperational or other types of risk.

" Operational risk itself is not new to financialinstitutions.

" OR is the first risk a bank must manage, evenbefore making its first loan or executing its firsttrade. "




Bank For International Settlement (BIS)

" A forum to promote discussion and facilitate decision-

making processes among central banks.

" A centre for economic and monetary research.

" Prime counterparty for central banks in their financialtransactions.

" Agent or trustee in connection with internationalfinancial operations.

An international organization which fosters inter-national monetary and financial cooperation and

serves as a bank for central banks.




BIS…Continues

" The Board of Directors, currently chaired by

Christian Noyer, Paris (3 September 2012).

" The Governors of the G10 central banks(Belgium, Canada, France, Germany, Italy,

Japan, the Netherlands, Sweden, Switzerland,the United Kingdom and the United States)have established a number of standingcommittees over the course of the past40 years to study basic issues, and/orelaborate best practices, regarding thefunctioning and architecture of internationalf i n a n c i a l m a r k e t s .




Group of Ten (G10) committees

" The most important committees are, inchronological order of establishment:" the Markets Committee (1962)"the Committee on the Global Financial System (1971)" the Basel Committee on Banking Supervision (1974)

" theCommittee on Payment and SettlementSystems (1990)




" Established in 1974 by Central Bank Governors of G10.

" Forum for international cooperation amongsupervisors.

" Committee of bank supervisors from 13countries (including G10).

" BIS provides meeting place and secretariat.

" Extensive outreach to other countries.


Basel Committee on Banking Supervision



BIS vs Basel

" The Bank for International Settlements," runs Basel Committee on Banking Supervision," formulates supervisory standards and best practice,

" no supranational authority (with local regulators).

" Not a regulatory body but …

" applied by G10 to major international banks," used by most of the rest of the world as standard,

" Established in 1930, head office Basel.

" Basel Capital Accord (Basel I),"

established in 1988," set minimum standards of capital adequacy,

" New Capital Accord (Basel II) proposed in 1999.




How many ways to spell?" Basel?

"Bale?" Basle?




Weaknesses of the Basel I

" Capital required does not mirror a bank strue risk profile.

" Can be easily arbitraged (securitisation)." Incentive to take high quality assets off

the balance sheet." Not much recognition of credit risk mitigates.




Basel II . . . The New Accord

Basel II Capital Accord Has

Evolved As A Complex Set Of Recommendations That Will Likely

Create A Variety Of RegulatoryCompliance Challenges For Banks.




E-mail [email protected] Mobile 971 5 2842846

According To Basel II

P&L

Market Risk

Credit Risk

Operational Risk

(Revenue)

(Costs)

For the first time banks are considering impacts on theP&L from the cost side!

Earning Volatility




Key Elements of Basel II

Objective

l Demand more capital

from those entities thattake on more risk

l Improve measurementcapabilities and risk management

l Preserve the health of the financial system

l Align capital to the real risks

incurredl Generate incentives to improve

measurement, analysis and risk management

l Maintain the global level of capital in the financial system

l Contribute to the global level of capital in the financial system

l Contribute to the goal of amore solid and safer financialsystem, by means of thedevelopment of the threepillars.

Basic

Premises Adequate Capitalrelated to incurredrisk



Comparison between I and II

The existing Accord The proposed new Accord

Focus on a single risk measure More emphasis on banks’ own internal methodologies,

supervisory review, andmarket discipline

One size fits all Flexibility, menu of approaches,incentives for better risk management

Broad brush structure More risk sensitivity




Evolution of Capital Calculations

" 1988 Basel Capital Accord:

Capital Ratio = Total Capital

Credit Risk (RWA banking book)

" 1996 Basel Capital Accord:

Capital ratio = Total capital

credit risk+ market risk (trading book)

" A cushion against unexpected losses.




Large

Evolution of capital calculations

" Eligible capital = shareholders' equity and retained

earnings (tier 1 capital) + supplementary capital (tier 2

capital) as defined in the 1988 Accord + some short-ter

subordinated debt (tier 3 capital).

MinimumCapital

Requirements= 8% of

Risk-weightedAssets

Credit Risk-weighting

Market Risk-weighting

OperationalRisk-weighting

+ +

Lesser

Now variable& more

complex (3approaches)

Introduced1997, small

changes

Small

New andvariable (also

3 approaches)




BASEL II Overview

Calculated based on

credit, market and

operational risk.

Disclosure &

Market

Discipline

Regulatory

Review

Process

Capital Adequacy

1 2 3

Capital

Requirements

Operational control

and compliance with

Pillar 1 requirements.

Capital adequacy

and risk control will

be disclosed.

Many options on

approach to

calculation.

Only varies on Pillar 1

approach, otherwise

must comply with all.

Requirements are

common to all

regulated firms.

Implications on, and requirements for,

systems, processes & people




Capital Adequacy in a Nutshell

Pillar 3 – Market discipline

Pillar 2 – Supervisory review

Pillar 1 – Minimum capital requirements

Minimum capital ratio

8 %

CapitalRWA[credit

risk

+ market

risk

+operational ]

risk

No change

No change

Big changes No changeNew

RWA = Risk Weighted AssetsE-mail: [email protected] Mobile+ 971 5 2842846



Basel II, in SummaryBasel II

Strategies

Pillar 1(Capital Strategy)

Pillar 1Compliance

RiskManagement

Pillar 3(Disclosure)

Pillar 2(Regulation)

Pillar 2Compliance

Create RiskCulture

• Human Resources

• Communications

• Reporting

• Training

• Approved persons

• Procedures Manuals

• Company Handbooks

• Regulatory Compliance

• Organisational Structure

• Risk Categorisation

• Assessment

• Process improvement

Strategies andPerformance for:• Capital Adequacy

• Risk Management

• Risk Event Handling

Risk EventHandling

• Monitoring

• Event Recording

• Event Management

• Statistics

Risk EventData Base

Credit

Risk

Market

Risk

Opertnl.

Risk

IRBAdvanced

Value atRisk

AdvancedMeasrmnt.

InternalRatingsBased

Standard-ised

Standard-ised

Standard-ised Basic

High Medium Low

2007

2007 2004+

2004+

2004+




Islamic Bank Risk Identification




Risk Profile for Islamic Banks




Generic Risks for Banks" Credit risk : the potential that a counterparty fails to meet

its obligations in accordance with agreed terms andconditions of a credit-related contract.

" Market risk : the potential impact of adverse pricemovements such as: benchmark rates, foreign exchangerates, equity prices on the economic value of an asset.

" Liquidity risk : the potential loss arising from the Bank’sinability either to meet its obligations or to fund increases inassets as they fall due without incurring unacceptable costs

or losses." Operational risk : the potential loss resulting frominadequate or failed internal processes, people and systemor external events.




Risks Are Highly Interdependent

BusinessRisk

OperationalRisk

FinancialRisk

IT and businessprocess

outsourcing

Derivativesdocumentation

and counterparty

risk

FX risk in a newforeign market

Financial Risks

MarketRisk

LiquidityRisk

CreditRisk

Credit Risk Associated with

Investments

Credit Risk Associated withBorrowers and

CounterpartiesFunding Liquidity

Asset Liquidity





Unique Islamic Bank Risks

l Shariah non-compliance Risk:

Risk arises from the failure to comply with theShariah rules and principles.

l Rate of return Risk:

The potential impact on the returns caused by

unexpected change in the rate of returns.




Unique Islamic Bank Risks…Continues

l Displaced Commercial Risk:

The Risk that the bank may confront commercialpressure to pay returns that exceed the rate that hasbeen earned on its assets financed by investmentaccount holders.

The bank foregoes part or its entire share of profit inorder to retain its fund providers and dissuade themfrom with drawing their funds.




Unique Islamic Bank Risks…Continues

l Equity Investment risk:The risk arising from entering into a partnership for the

purpose of undertaking or participating in a particularfinancing or general business activity as described in the

contract, and in which the provider of finance shares inthe business risk.

This risk is relevant under Mudharabah and Musharakah contracts.



Concept of Risk Management in Islam


follow Concept of Risk



…follow Concept of Risk

Management in Islam





Text in Al-Qur’an “O my children, do not enter the capital of Egypt by one gate but go into it by differentgates. However, knowlit well that I cannot

warddoff you Allah’s will for none other thanHe has nay authority whatsoever. In Him Ihave put my trust and all who want to relyupon anyone should put their trust in Him

alone.” (Yusuf: 67)


Management in Islam





Hadith from the Prophet s.a.w

Prophet s.a. wonce asked a Beduin who hadleft his camel untied, “Why do you not tie

your camel?” The Beduin answered: “I putmy trust in God.” The Prophet s.a. then said, “tie up your camel first then put your trust inGod.”


Management in Islam





A Bank’s business (whether Islamic orConventional) is to take calculated risks.

Risk Management is not the minimization of

losses but the optimization of the risk rewardequation.

The competitive advantage of a Bank isdependent on how well it manages risk.


Management in Islam






Management in Islam




Islamic Banking and

Operational Risk




Operational Risk Definition,

and Identification

l k



Operational Risk

" The Basel Committee defines operational risk as

“the risk of loss resulting from inadequate or failed internal processes, people, and

systems, or from external events.”

" Includes legal risks." Excludes reputation and strategic risks.



Operational risk: examples

" Fraud:

insider trading, misappropriation of assets.

" Natural disasters:

earthquake, terrorism.

" System related failures:

power down, technical breakdowns.



Operation risk: capital requirement

Basic indicator

Approach

15% of gross income

Standardized

Approach

Different percentages(12-18%) applied toeight different business segments

AdvancedMeasurement

Approach(AMA)

Generated by bank ’s own operational risk measurement systems (subject tosatisfying min supervisory standards

O i l Ri k i IB



Operational Risk in IBs

Operational risks are likely to be significant for Islamic banks due to

their specific contractual features and the general legal environment.

O ti l i k i IB



Operational risk in IBs …continues

"Cancellation risks in the nonbinding Murabahah (cost-plus sales) and Istisnah (manufacturing)contracts.

" Failure to comply with Shariah requirements.

" Potential difficulties in enforcing Islamiccontracts in a broader legal.

" Need to maintain and manage commodity

inventories often in illiquid markets." Potential costs and risks of monitoring equity-

type contracts and the associated legal risks.

Ph i ll E l f OR i IB



Physically Example of OR in IBs

An internal control problem cost the Dubai Islamic Bank $50 million in 1998 when abank official did not conform to the bank’s

credit terms.This resulted in a one-day run on the bank’sdeposits to the tune of $138 million,representing 7% of the bank’s total

deposits.

(Warde 2000)

Some suggestions to Financial Inst



Some suggestions to Financial Inst

"Know your local regulatory requirements." Cost/benefit is the key.

" Consider simple solutions first.

" Operational risk is more than compliance, it isa business requirement.

" Culture is a key area.

" Start now.




Change

The RulesOf TheGame

From

managing

the cost of doing

business

to . . . .

To being

more

proactive

!Running Away Is Not The Way To

Manage Risk; Face It Head-On!



Dr. Elias Abu AL-

Haija



57

U f l f



Useful references

" www.bis.org

" www.federalreserve.gov/generalinfo/basel2

" Consulting Paper of the Basel II Accord June

1999

" Consulting Paper of the Basel II AccordJanuary 2001

" QIS 3 Technical Guidance

" The new Basel Capital Accord

risk management for islamic financial institutions - by elias aby alhaija - icompetences ifc2012

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