Why it is important to Islamic risk management

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RISK MANAGEMENT AND CORPORATE
GOVERNANCE IN ISLAMIC FINANCIAL
INSTITUTIONS
ZULKIFLI HASAN
HAWKAMAH, THE INSTITUTE OF CORPORATE GOVERNANCE
26TH MARCH 2009
CONTENTS
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Introduction
Case Study: Closure of Ihlas Finance, due to Poor
Corporate governance (CG)
What is CG?
Why it is important to Islamic risk management
system?
Elements of Good CG in IFIs
Risk Management in IFIs
Roles of Board of Directors (BOD) and Senior
Management
Roles of Shari’ah Board
Concluding Remarks
Financial Distress and Failure of Ihlas Finans
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Financial Crisis in Turkey 2000-2001. One
Islamic institution Ihlas Finans (the first
domestic IFI in Turkey) was closed during the
crisis while the other five Islamic banks were
survived.
Ihlas Finans is a special finance house
established in 1995 and was a subsidiary of Ihlas
Holdings.
The BRSA cancelled the license of Ihlas Finans
on 10th February 2001.
Factors
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Accumulation of bad debt- Politically motivated lending
and lending to connected business. Finance the businesses
of its parent company, Ihlas Holdings.
Lax Regulation- Law on full guarantee of the bank deposits
offered by the State made banking a lucrative business for
the corrupt entrepreneurs with political connections who
set up banks that siphoned off money.
Major proportion of the investment was an illiquid assets
and projects as compared to other domestic and foreign
commercial banks who could hold very liquid government
securities.
Failures in CG and lack of internal checks and balances:Control failure, Management failure and regulatory failure.
A rubber stamp board of directors,
Lax Attitude towards governance,
Some members appointed to the
board did not have requisite
experience, Only one institutional
member i.e. IDB as minority
shareholder and thus it was easy to
manipulate the Board
Board members are ignorant of
financial and economic facts and
working of the company , board
members are not motivated, Some
board members had conflict of
interest owing to their dual role as
board members as well as clients of
finance from Ihlas Finans Holdings
Control
Failures
The Bank staff lack relevant
experience and training
The bank is run on trust
without proper systems of
internal control
Not preparing enough for
changing regulations, No
Crisis Management Plan,
Decision making during crisis
was ad-hoc and
uncoordinated internally
Connected Lending and
Investment Concentration,
Executive Selection Hired a
senior executive from a
previously failed bank
Management
Failures
Allowing Withdrawal from
Investment Accounts,
Failure to manage liquidity
risk
Indulge in fraudulent
practices, some of the
mudharabah agency financing
was done in the name of
fictitious parties while the
funds were used for solving
internal financial problems
Drastic application
of rules
Lax Supervision
Regulatory
Failures
Lacuna in
supervision of law
Unclear scope of
deposit protection
law and confusion on
who is the authority
What is CG?
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CG is the system by which business corporations are
directed and controlled .
CG specifies the distribution of rights and
responsibilities among different participants in the
company such as BOD, Shari’ah board, managers,
shareholders, and other stakeholders.
A concept of CG in IFIs presents distinct
characteristics and features in comparison with the
conventional system as it goes beyond the financial
return whereby it covers the element of ethic,
Shari’ah and beliefs (aqidah).
Shari’ah board plays significant role to supervise ,
oversea and advise the shari’ah aspects of the
corporation.
Why CG is important for risk management in
IFIs?
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Hypothesis 1: Weak CG may lead to
ineffective risk management system.
Hypothesis 2: Strong commitment to good
CG will improve and strengthen risk
management system in IFIs
Case Study: Ihlas Finans was closed in 2001
due to poor CG while the other five Islamic
banks in Turkey were survived because of
better CG.
Existing Studies
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Well governed UK companies posted 18% higher returns
than those with poor governance after adjusting for risk
(ABI Research Paper 7: 2008);
Well governed firms in Korea have been found to trade at a
premium of 160% to poorly governed firms (Black, B Et al:
2004);
A study of S&P 500 firms showed that companies with
strong or improving CG practices outperformed those with
poor or deteriorating governance practices by about 19%
over a 2-year period (Grandmont, R Et al: 2004).
A worst-to-best improvement in CG predicted an
astronomical 700-fold increase in firm value among Russian
firms (Black, B: 2001).
The Six Elements of Good CG in IFIs
Good Board
Practice
Sound Shari’ah
Governance
system
Disclosure and
Transparency
Commitment to
Good CG
Control
Environment and
Processes
Shareholders Right
Risk Management in IFIs
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Certain types of risks are of equal concern to all
financial institutions, including IFIs.
IFIs face additional risks that emanate from the
unique characteristics of Islamic finance
transactions, along with risks associated with the
real or perceived non-compliance of Shariah
principles.
The survival and success of IFIs depends on the
efficiency in which they can manage its risks and
how they will manage different risks arising
from their operations.
How good CG may improve Risk Management
System?
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IFIs shall have in place a comprehensive risk
management and reporting process, including
appropriate board and senior management oversight,
to identify, measure, monitor, report and control
relevant categories of risks and, where appropriate,
to hold adequate capital against these risks.
The process shall take into account appropriate steps
to comply with Sharī`ah rules and principles and to
ensure the adequacy of relevant risk reporting to the
supervisory authority.
Risk Management in IFIs
Board and
Senior
Management
Shari’ah Board
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Credit Risk
Equity Investment Risk
Market Risk
Liquidity Risk
Rate of Return Risk
Operational Risk
• Shari’ah Non-compliance
Risk
Roles of Board and Senior Management
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Approve the risk management objectives, strategies,
policies and procedures ;
Ensure the existence of an effective risk management
structure for conducting IFIs’ activities, including
adequate systems for measuring, monitoring,
reporting and controlling risk exposures;
IFIs shall have in place an appropriate body, in
accordance with sound principles of CG, to oversee
that all products and activities comply with Sharī`ah
rules and principles as approved in each jurisdiction.
Cont…
 Approve limits on aggregate financing and investment
exposures to avoid concentration of risk and, ensure
that IFIs hold adequate capital against these
exposures.
 Review the effectiveness of the risk management
activities periodically and make appropriate changes
as and when necessary.
 Execute the strategic direction set by the BOD on an
ongoing basis and set clear lines of authority and
responsibility;
 Senior management shall ensure that the risk
management function is independent from the risktaking activities and is reporting directly to the BOD
or senior management outside the risk-taking unit.
Types of Risk
Roles of BOD and Senior Management
Credit Risk
•Strategy for financing and recognize the potential credit exposures.
•Carry out due diligence review
•Appropriate methodologies for measuring and reporting credit risk
exposure
•Shariah-compliant credit risk mitigating techniques
Equity
Investment Risk
•Strategy for risk characteristics of equity investments
•Appropriate valuation methodologies
•Establish exit strategies in respect of equity investment activities
Market Risk
•Appropriate framework for market risk management in respect of
all assets held
Liquidity Risk
•Appropriate liquidity management framework
•Able to assume that liquidity risk commensurate with their ability to
have sufficient recourse to Shariah-compliant funds to mitigate such
risks
Rate of Return
Risk
•Comprehensive risk management and reporting process to assess
the potential impacts of market factors affecting rates of returns on
assets in comparison with the expected returns for IAH
Operational Risk
•Adequate system and controls to ensure Shariah compliance
•Appropriate mechanism to safeguard the interest of all fund
providers.
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Roles of Shari’ah Board
IFIs shall have adequate system of controls
including Shari’ah governance (SG) system.
SG is a set of institutional and organizational
arrangements through which IFIs ensure that
there is independent oversight of Shari’ah
compliance.
IFIs shall have in place a Shari’ah board (SB) to
review and ensure that all financing proposals
are Shari’ah compliant at all times.
Internal/External Shari’ah review unit to assist
the SB for Shari’ah-compliance purpose.
How Shari’ah governance complements the
existing corporate governance?
Functions
Typical Financial
Institution
Exclusive to IFIs
Governance
Board of Directors
Shari’ah board
Control
Internal Auditor and
External Auditor
Internal Shariah Review
Unit/ External Shari’ah
review
Compliance
Regulatory and financial
compliance officers,
unit or department
Internal Shari’ah
compliance unit
Shari’ah Non-Compliance Risk
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IFIs are exposed to risk relating to Shari’ah noncompliance risks and also to reputational risk.
These risk exposes IFIs to fund providers’ withdrawals,
loss of income or voiding contracts leading to a
diminished reputation or the limitation of business
opportunities.
IFIs shall at all times comply with the Shari’ah rules and
principles as determined by the SB with respect to
products, activities and contract documentation.
IFIs shall undertake a Shari’ah compliance review.
IFIs shall keep track of income not recognized arising
out of Shari’ah non-compliance.
Some Impact of Shari’ah Non-Compliance Risk
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Slowdown of global Sukuk issuance.
By the end of 2008, global Sukuk issuance had declined by
more than 50% compared to 2007.
Chairman of the AAOIFI Shari’ah board- criticized a
common form of sukuk that apparently violates the Shariacompliant principles surrounding risk and profit-sharing.
He estimated that up to 85% of Gulf Sukuk structures
were not Shari’ah-compliant.
AAOIFI made a recommendation to Islamic finance
market participants to refrain from issuing Sukuk
structures that have a purchase undertaking or guarantee
from the Sukuk issuer to repurchase at a future date at a
specific price.
Elements of Good Shari’ah Board
Independence
Clear Mandate
and
Responsibility
Competence
Acceptable fit and
Proper Criteria
Sound Code of
Ethics and
conduct
Transparent and
Disclosure
Well-defined
Operating
Procedures
Concluding Remarks
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Good CG is crucial in providing effective risk
management system.
Certain types of risks are of equal concern to all
institutions offering financial services, but there are
certain specific risks which are exclusive to IFIs.
Board of Directors and Senior management have
specific roles in relation to risk management
objectives, strategies, policies and procedures in order
to mitigate all types of risks.
Shari’ah board is more concerned on the aspect of
Shari’ah non-compliance and reputational risks.
IFIs need for a set of best practices of corporate
governance and effective risk Management that give
practical effect to managing the underlying risks.
References
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Ali, Salman Syed (2007). Financial Distress and Bank Failure: Lessons from Closure
of Ihlas Finans in Turkey, Islamic Economic Studies, Vol. 14, No. 1 & 2, Aug. 2006
& Jan. 2007, pp: 1-52.
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ABI Research Paper 7. (February 2008). Governance and Performance in Corporate
Britain. London: The Association of British Insurers.
Black, B. S. Jang, H and Kim, W (2004). Predicting Firms CG Choices: Evidence
From Korea. University of Texas Law School Working Paper No. 39, August.
Black, B. (2001). The CG Behavior and Market Value of Russian Firms. Emerging
Market Review, Vol. 2, March.
Grandmont, R, Grant, G. and Silva, F. (2004). Beyond the Numbers- CG:
Implications for Investors, (Deutsche Bank, April 1).
Hijazi, Faisal. (2009). Global Sukuk Issuance: 2008 Slowdown Mainly Due to Credit
Crisis and Some Impact on Shari’ah compliance issues. International Structured
Finance Special Report.
IFC and Hawkamah. (2008). A Corporate Governance Survey of Listed Companies
and Banks Across the Middle East & North Africa. Washington: IFC.
IFSB Exposure Draft Guiding Principles on Shari’ah Governance System.
IFSB Guiding Principles of Risk Management For Institutions (Other then
Insurance Institutions) Offering Only Islamic Financial Services.
Thank You
Zulkifli Hasan
E-mail: zul361977@yahoo.com
z.b.hasan@durham.ac.uk
Blog: http://zulkiflihasan.wordpress.com
Tel: +44 (0) 7761457686
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