Pre-Examination Session
Class Review
IB2002 Risk Management for IFIs
Prof. Saiful Azhar Rosly, Banking Department
INCEIF
Risk Management
Risk management is a continuing process of
corporate risk reduction
Risk management is about how firm actively select
the type and level of risk that is appropriate for them
to assume.
Risk management and risk taking are two sides of the
same coin.
Business risk
• Potential loss in the world of business due to uncertainty
about:
1. Demand for products
2. The price that can be charged for those products
3. The cost of producing and delivery the products
Risk is potential loss
 Risk itself is not an evil thing
 Avoiding risk with zero profit is allowed – WadiahYad
Dhamanah deposit
 Avoiding risk with positive profit is not allowed – interest
from loans.
 Avoiding risk is an evil action if it injures the counterparty –
interest from loans
Risk Management in Islamic Banking
• Fundamental principle in Islamic business :
a. no reward without risk – al-ghorm bil ghonm
b. With profit comes liability – al-kharaj bil daman.
• Risk taking behaviour – as the above –
risk > 0, profit > 0
permissible
• Risk avoiding behaviour – risk =0, profit >0 - not permissible
2 dimensions of Islamic bank
risk management
Profitability
(Making profit with risk)
Banking book
Credit risk
Market risk, operational risk
Liquidity risk
RoR, DCR,
Shariah risk
Financial stability
Trading book
Basel II
IFSB
Market risk
Operational risk
Legal risk
1. Capital Adequacy
2. Supervision
3. Market discipline
Profitability vs Financial Stability
 Banks as profit-maximizing firms cannot be left alone
without proper regulations by authorities.
 Banks may take excessive risks and overlooked safety of
depositors’ fund, eroding capital and thus jeopardizing
public confidence.
 Thus in making profit, banks may introduce financial
instabilities.
 The purpose of regulation is to instill financial stability by
controlling bank’s behaviour.
Loss due
Risk
exposures
Reduce
Earnings
Reduce
Capital
Bank
Failure
Financial
Instability
Unexpected
Loss
Capital
Depletion
Insolvent
Banks
Credit
Crunch
Recession
5 Basic Shariah Principles in Financial
Transactions
#1
Riba
Prohibition of
#2
Application of Al-Bay
#3
Avoidance of Gharar
#4
Prohibition of Gambling(Maisir)
#5
Prohibition of Impure
Commodities
Islamic Bank Risk Management
Process
Appraisal
& Due Diligence
• Credit Scoring
• PD, LGPD
• Business Plans
• Cash Flows
Take Position
• Pricing
• Risk premium
• Security
Monitoring
• Effects of Exposure due to Systematic and Unsystematic
risks
• Risk Mitigation
Risk Management
Take Position: Risk-Taking
Impact on Firm
OPTIONS OF RISK MANAGEMENT
Risk
Avoidance
Risk
Prevention/Reduction/
Mitigation
Risk Transfer
Insurance
Derivatives
Failures of Risk Management
Long-Term Capital Management (LTCM)
Enron
WorldCom
Global Crossing
Parmalat
Lehman
Morgan Stanley
AIG
Bears & Stearn
Northernrock
Washington Mutual
More coming soon… subprime world crisis
Islamic Bank’s Average Balance Sheet
Asset
Liability
Cash
Wadiah Dhamanah Current
Account
BBA Home Financing
Wadiah Dhamanah Savings Account
AITAB Car Financing
Restricted Mudarabah Account
Bay al-Inah Personal Financing
Enterprise Financing
Unrestricted Mudarabah Account
Government Islamic Securities
Commodity Murabahah
Negotiable Islamic Certificate of
Deposits
Sukuk
Fixed Assets
Shareholders’ Capital
Income Statement
‘Reward comes with Risk”
Islamic Banking
Profit and Loss
Revenues
Cost of Funds
$500m
$200m
Gross Profit
$300m
Overheads
Provisions for NPF
Profit Equalization Reserve
$80m
$10m
$10m
Profit Before Tax and Zakat
$200m
Tax and Zakat
$60m
Net Profit
$140m
Credit Risk
Rate
of Return
Risk
Shariah
Risk
Market Risk
Islamic
Banking
Risk
Displace
Commercial
Risk
Operational
Risk
Liquidity
Risk
Common Risks
1. Credit risk
2. Market riks
3.Operational risk
Peculiar Risks
1. Rate of return risk
2. Displaced
commercial risk
3.Shariah risk
Total Risks faced by
Islamic Banks
Common
Risks
Peculiar Risks
Profit Equalization
Reserve
Displaced
Commercial Risk
Rate of Return Risk
Market Risk
(Negative Income gap)
SHARIAH RISK
Foreclosure & civil court decision
concerning validity of Islamic banking
products
Default
Credit Risk
Risk
Banking
Book
Eg. BBA
Trading Book
Eg. Sukuk
Risks in BBA
Financing
Credit Risk
Low credit scoring for
Islamic customers,
higher probability of
default
Market Risk
Negative Gap can mean
losses as
Interest rate increases
Shariah Risk
Recent Court
Judgement
on murabaha/BBA as
non bona fide sale
(PD)
High NPF and WriteOffs
Capital Depletion
Earning at risk (EAR)
Capital at risk (EAR)
Litigation Costs
Erosion of earnings
Operational
Risk
Conventional
solution/system not able to
accomodate Islamic accounting
principles leading to
overcharging and undercharging
customers.
Increase
Overheads
Litigation costs
Risk-taking
Once the bank accepts the risk, it must manage it.
What are the risks faced by an Islamic bank?
The Islamic bank’s shareholders face the following risks:
Credit risk
Market risk
Liquidity risk
Operational risk
Commercial displacement risk
Rate of return risk
Shariah risk
Losses arising from risky financing facilities will adversely affect deposits and
shareholders’ capital.
• The objective of banking regulation (Basel II) is to protect deposits.
• When losses wiped out bank’s capital, the bank becomes insolvent.
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1.
2.
3.
4.
5.
6.
7.
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Risk Management in Islamic Banking
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Concept of risk in Islam
Risk in trading and commercial transactions (al-bay)
Risk in loans
Types of risk
Systematic , pure and speculative risk
Unsystematic
Islamic Banking business
Operates under Basel II
Basel II – to protect depositors’ fund
Capital adequacy requirement
Risk management –
Before bank approves financing facilities, it:
Identify risk
Measure risk
Pricing
Risk mitigation
collateral
risk transfers via derivatives
Islamic Banking Balance Sheet
Asset
Risk Weight
Murabahah $6000m
Ijarah
1.00
$2000m
1.50
Mudarabah $1000m
2.00
Musharakah $1000m
2.50
Others
$500m
Liability
Wadiah dhamanah $2000m
Mudarabah investment deposits $8000m
0.5
Capital ?
CAR = 10%
Capital ratio = Eligible Capital / Risk-Weights Assets (RWA)
= $?m/RWA
Eligible Capital = Capital ratio x RWA
= 0.1 / (6000 x 1) + (2000 x 1.5) + (1000 x 2.0) + ($1000 x 2.5) + ($500 x 0.5) =______?
Highly risky assets carry high conversion factor (Risk Weight)
Islamic bank must carry more capital in order to conduct risky business.
Risk / Potential losses
• Murabaha : sale with installment payments
Credit risk
Shariah risk
• Ijarah: financial leasing – leasing ending with sale
Credit risk
Market risk
Shariah risk
• Partnership: profit-sharing
Market risk
Operational risk
Islamic Banking
Profit and Loss
Revenues
Cost of Funds
$500m
$200m
Gross Profit
$300m
Overheads
Provisions for NPF
Profit Equalization Reserve
$80m
$10m
$5m
Profit Before Tax and Zakat
$200m
Tax and Zakat
$60m
Net Profit
$140m
Credit Risk
Credit risk
Credit risk is the risk that a change in the credit quality of a
counterparty will affect the value of a security or portfolio.
• When counterparty defaults, the bank loses either all of the
market value of the position or, the part of the value that it
cannot recover.
a. Expected loss (LGD loss given default) – covered by
provisions
b. Unexpected loss – covered by capital
•
Islamic Banks
that thrived on
Credit Financing
Loss due to
Credit risk is
inevitable
Basel II and Credit Risk
Expected Loss
(Covered by
bank’s
provisions)
Unexpected
Loss
(Covered by
capital)
Total Loss
Loss due
Credit Risk
Rising
NonPerforming
Financing
Reduce
Earnings
Capital
Depletion
Bank
Failure
Financial
Instability
Credit Risk Management
 Adverse selection and moral hazard
 Moral hazard exists because borrowers may have
incentive to engage in activities that are undesirable
from lender’s point of view
 In such situations, it is more likely that the lender will
be subject to the hazard of default
 Banks have to overcome the adverse selection and
moral hazard problem that make loan defaults more
likely.
Credit Risk Management
This is done by
Screening
Monitoring & enforcing restrictive covenants
Establishment of long term customer
relationships
Loan commitment
Specialized lending
Collateral and compensating balance
requirements
Credit rationing
Total Loss
Expected Loss
Unexpected Loss
Largely due to
unsystematic risk
Largely due to
systematic risk
Credit Risk in BBA
• The risk of the facility is characterized by:
1. The external and /or internal rating attributed to each
obligor, usually mapped to probability of default (PD).
2. The loss rate given default (LRGD) and EAGD of the
facilities. LRGD is the loss rate when the borrower defaults.
3. Exposure at given default (EAGD) : notional value of a loan,
or exposure for loan commitment. Amount of credit
outstanding at the time of default.
 The expected loss (EL) for each credit facility:
EL = PD x EAGD x LRGD
Example: Expected Loss
 Zahidi Bank hold a $500 million BBA portfolio with 15 years
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tenor.
PD of the portfolio = 10%
BBA defaulted after 5 years
Exposure at given default (EAGD) = $400
Collateral $300m
Loss rate given default = (EAGD – collateral)/$500m = ($400m
- $300m)/$500m = ($100/$500) x 100% = 20%
EL= PD x EAGD x LRGD
EL = 0.1 x $400m x 0.2 = $8 million
Bank will put aside $8 million for NPF provisioning.
EXPECTED LOSS = PD x EAGD x LRGD
EAGD = $400m
Origination
PD = 10%
Maturity
Default
BBA PORTFOLIO = $500m
Expected Loss is covered by Bank’s
Provisioning
General and
Specific
Provisions
Expected Loss
(EL)
Probability of
Default (PD)
Loss Rate
Given Default
(LRGD)
Exposure at
Given Default
(EAGD)
Credit risk inn BBA
• Expected loss (EL) is the basis for the calculation of the
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•
•
•
bank’s allowance for BBA losses, which should be sufficient
to absorb both specific and general credit related losses.
EL can be viewed as cost of doing business. That is, on
average, the bank will incur a credit loss amounting to EL.
However ACTUAL credit losses may be higher or lower than
EL.
The variation for credit losses beyond EL is called
unexpected loss (UL).
UL is the basis for the calculation of economic and regulatory
capital.
Assessing credit exposure
 Compute EL
 Compute UL
 Determine the volatility of expected loss of a BBA to the
whole portfolio.
 Calculate the probability distribution of credit loss for the
portfolio and asses the capital required to absorb the
unexpected losses.
Pricing, Credit risk and Expected Loss
How does an Islamic bank pass on the cost of nonperforming financing provisions to the customers?
Pricing of Debt instrument.
Profit rate = Cost of deposits + cost of overheads + risk
premium
Cost of
Deposits
RiskPremiums
Banking
Products
Statutory
margins
Overheads
 Bank’s contractual loan rate is equal to the:
a. cost of deposits (rd),
b. operating costs (c),
c. Statutory profit margin (p) and
d.
a risk premium.
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If we take away the risk premium, we get the targeted interestrate (r t), which is also known as the prime or base-lending rate
(BLR).
The BLR is the interest rate charged to bank’s best customers
consisting of the interest rate on deposits (rd) operating cost (c)
and a profit margin (p).
 Based on the above r t = rd + c + p.
 Let’s say that bank pays depositors 7% and incurred 1% in
operating cost and a 2% profit margin.
 The targeted interest rate is therefore 10%.
 Now the bank receives a $180,000 BBA application from
Salim. After full assessment of his credit ratings, the bank felt
that Salim has a 20% default risk (pd = 0.2).
 This also implies that the probability of Salim making full
payment is 80% (pf).
 Given this information, the question now is how much
should the bank charge Salim for the $180,000 BBA?
 Or what is the contractual profit rate (rc)?
 The contractual profit interest rate is the rate set in the BBA
contract in arriving at the selling price (SP).
 Given that Salim is a risky customer, the bank may not want
to charge him the prime rate. The prime rate is the rate the
bank charges to its best customer. Certainly now, the
contractual profit rate is expected to be higher than the
prime rate or BFR.
 To obtain the contractual profit rate, the bank must first
determine how much profits it desires to make from the
BBA. Meaning that the expected rate of return (re) must be
computed to find (rc).
 Since the bank’s targeted rate of return (r t) is equal to the
BFR, it also means that expected rate of return (re) must be
equal to the targeted rate of return (r t).
 r t = re
 Now given Salim’s 20% probability of default, which is
assumed to cause the bank a 10% loss (rd), [also known as
loss rate given default LRGD in a BBA portfolio] the
expected rate of return (rc) and contractual profit rate are
given below:
Computing the Contractual profit rate
(rc) on a Risky BBA
 re = (pf x rc) + (pd x rd)
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 re = (0.8 x rc) + (0.2 x -0.1)
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 r t = rd + c + p
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 Since r t = 10% or 0.1
 = 0.8rc - 0.02
 rc = (0.1 + 0.02)/0.8 = 0.15 or 15%; rc  r t
 We can see in the above illustration that the pricing of BBA has
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included the credit risk factor. It has also added earlier the timevalue of money factor.
Profit rate = cost of GIA deposit (TVM) + OVH + credit risk
the contractual profit rate (rc = 15%) is higher that the targeted
rate of return (r t = 10%). This is simply because Salim is a risky
customer thus was charged 5% higher than the bank’s best
customer(s) who by definition have no credit or default risk at all.
In other words, for risky borrowers, the contractual profit rate is
set above the targeted rate.
Likewise, the lower the default risk, the lower is the contractual
profit rate relative to the targeted rate.
Why is this allowed BBA and disallowed in loans?
Credit Risk Premium and EL
 Based on the calculated contracted rate of return (Rc), it is
found that the bank charges an extra 5% based on the credit
worthiness of customer.
 This 5% risk premium is used by the bank to cover the
Expected Loss or the expenses on BBA loss provisioning.
Islamic Banking
Profit and Loss
Revenues
Cost of Funds
$500m (Rc x F)
$200m (Rd x D)
Gross Profit
$300m
Overheads
Provisions for NPF
Profit Equalization Reserve
$80m
$10m
$10m
Profit Before Tax and Zakat
$200m
Tax and Zakat
$60m
Net Profit
$140m
Rc = cost of deposit + overhead + risk premium
Risk premium is
used to pay for
unexpected loss (UL)
or NPF provisioning.
Market Risk
Profit-rate risk
Rate-Sensitivity of Islamic Banking
Products
Impact on Earnings
Market risk
Risk measurement
in Banking Portfolio
Banking Book
Mortage
Hire Purchase
Corporate
Bonds
Earning at Risk
Trading Book
Bonds
Value at Risk
Income Gap Analysis
 Impact on income from changes in profit-rate
 GAP = Rate sensitive assets (RSA) – Rate sensitive liabilities
(RSL)
 Change in income = GAP x (change in profit rate)
Income Gap Analysis
• Fixed rate asset (FRA)
1. BBA(F)
2. AITAB
3. Tawaruq PF
• Flexible rate asset
(VRA or RSA)
1. Mudarabah
2. Musharakah
3. BBA(V)
• Fixed rate liabilities
(FRL)
1. CMD (Commodity
Murabaha)
2. NICD
• Variable rate liabilities
(VRL or RSL)
1. WAD
2. PSIA
3. INI
Salam Bank Balance Sheet
Asset
BBA
AITAB
Tawaruq PF
Mudarabah
$700m
$400m
$100m
$ 50m
Fixed Asset
$ 100m
Liability
Wadiah Dhamanah
PSIA
CMD
Capital
$100m
$200m
$800m
$250m
GAP = $50m - $1000m = -$950m
FRA
1. BBA
$700m
2.AITAB
$400m
3. Tawaruq
$100m
Total
$1200m
RSA
1. Mudarabah $50m
GAP = -$950
If profit rate decreases by 1%,
then net income will increase
by (-$950m x 0.01) = $9.5m
RSL
1. WAD$200m
2. PSIA $800m
Total
$1000m
RSL
1. WAD & PSIA $1000
GAP = -$950
If profit rate increases by 1%,
then net income will fall by ($950m x 0.01) = $9.5m.
To make GAP = 0
 Increase RSA
 Decrease RSL
But to decrease RSL will mean adding more fixed rate deposits
(FRD).
FRD = CMD, NICD.
When GAP = 0, any changes in profit rate/interest rate will
not affect income.
How to mitigate interest-rate risk in
Islamic banking?
 Offering Floating-Rate BBA products
 BBA securitization
 Profit-rate Swap (PRS)
Floating Rate BBA/Murabaha
 Islamic Bank expects interest rate to increase.
 Set up the maximum rate
 Market rate = 5%
 Maximum rate = 10% (based on bank’s forecast)
 Cost of asset = $200,000
 Tenure = 10 years
 Aqad price = $200,000 + ($200,000 x 0.1 x 10) = $400,000
 Monthly payment = $400,000/120 = $3333.
 Selling price based on current rate = $200,000 + ($200,000 x 0.05 x 10) =
$200,000 + $100,000 = $300,000
 Monthly payment = $2500 = Actual payment
 Rebate = $3333 - $2500 = $833
Floating rate BBA/Murabaha
 If rate increases to 6%, SP = $200,000 + ($200,000 x
0.06 x 10) = $200,000 + $120,000 = $320,000
 Monthly payment = $2666
 Rebate = $3333 - $2666 = $667
 Islamic bank able to adjust the rate since the aqad price
remains the same based on the capping rate of 10%.
 As interest rate increases, rebate decreases.
Interest Rate Swap (IRS)
Fixed rate@Loan
10% @ Loan
Bank A
Bank B
Floating rate@Loan
BLR +1 @Loan
Bank A expects interest rate to increase
Bank B expects interest rate to fall
Actual thing: interest rate increases
Loan = $100m
1. Fixed Interest payment = 0.1 x $100m = $10
2. Floating interest payment = 0.12 x $100 = $12 million
3. Bank B pays Bank A $2 million.
4. No exchange of notional loan amount between Bank A and Bank B.
Profit Rate Swap (PRS)
Fixed rate@BBA
10% @ BBA
Bank A
Bank B
Floating rate@BBA
BLR +1 @ BBA
Bank A expects interest rate to increase
Bank B expects interest rate to fall
Actual thing: interest rate increases
Loan = $100m
1. Fixed profit-rate payment = 0.1 x $100m = $10
2. Floating profit rate payment = 0.12 x $100 = $12 million
3. Bank B pays Bank A $2 million.
4. No exchange of notional BBA amount between Bank A and Bank B.
Profit Rate Swap (PRS)
Stage 1
Sells asset in cash ie. notional
Bank A
Bank B
resell asset @ notional + fixed rate
Pay fixed rate
Bank A
Bank B
Profit Rate Swap (PRS)
Stage 2
Sells asset @notional + floating rate
Bank A
Bank B
resell asset @ notional (cash)
Pay floating rate
Bank A
Bank B
(credit)
Relationship between Market Risk
and Displaced Commercial Risk
-ve Gap – Market risk RoR
RoR  DCR
DCR  risk mitigation PER
Profit Equalization
Reserve
Displaced
Commercial Risk
Rate of Return Risk
Market Risk
(Negative Income gap)
Commercial displacement risk (DCR)
Deposits
 Expected rate of return < realized rate of return
 Customers may switch from Islamic deposits to conventional
deposits
 To prevent deposit migration, Islamic bank uses its own
reserves to top up the deficit.
 Total earning/profit declines.
• Gap = RSA – RSL
• Positive Gap: RSA > RSL
• Positive Gap: (RSA/RSL) > 1
• Negative Gap: RSA < RSL
• Negative Gap: (RSA/RSL) < 1
• Credit based (Murabaha) Islamic bank:
Most assets are fixed rate asset (FRA) or RISAs
Most liabilities (Wadiah&Mudarabah) are RSLs.
• Islamic bank faces Negative Gap ; RSA < RSL
Gap Analysis
Gap = RSA – RSL
Positive Gap: RSA > RSL
Positive Gap: (RSA/RSL) > 1
Negative Gap: RSA < RSL
Negative Gap: (RSA/RSL) < 1
Deposits
Wadiah Dhamanah
Mudarabah PSIA
Variable Rate Deposits
Commodity Murabaha
NICD
Fixed rate Deposits
Capital
Financing
Musharakah
Mudarabah
Variabale Rate Assets
BBA
AITAB
Fixed Rate Assets
Capital
Islamic Banking Realities:
Negative Gap Asset-Liability
RSA < RSL
Fixed Rate Deposits
Fixed Rate Assets
Variable Rate Deposits
(RSL)
Variable Rate Assets
(RSA)
BBA Intensive Islamic Banks
Most assets are fixed rate asset (FRA) or
RISAs
Most liabilities (Wadiah&Mudarabah) are
RSLs.
Islamic bank faces Negative Gap ; RSA < RSL
Rate of Return
Risk
Displacement
Commercial Risk
Profit
Equalization
Reserve
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•
•
•
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Potential loss arising from loss of deposits
Gap/Asset-Liability Mismatches
Rate of Islamic deposits < deposit interest rate
Rd < id
Actual rate of return < indicated/expected rate of return
• Potential loss that occurs when Shareholders’ Funds are utilized to “smoothen”
rate of return on Islamic deposits.
• Amount appropriated out of total income to main an acceptable level of
return on Islamic deposits.
• Serve to smoothen return on Islamic deposits (RoID).
• Increase PER provisions when RoID not competitive.
 Profit = ($100m x 0.07) – ($100 x 0.03)
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= $7m - $3m = $4m
When market interest rates go up, what can happen to the bank?
The bank cannot raise then profit rate to accommodate prevailing cost of fund. If it
does, the murabaha contract turns invalid.
The bank will lose deposits when Islamic deposit rate (IDR)< conventional interest
rates (CII).
When it losses deposits and forced to acquire money market funds at a higher cost,
the bank earning drops. This is known as the Displaced Commercial Risk (DCR).
To mitigate DCR, the Profit Equalization Reserve (PER) was instituted.
PER serves to fill the gap between IDR and CII. Or the expcted rate of return and
the realized rate of return.
Liquidity Risk
 Funding liquidity risk – a bank’s inability to mobilize deposits
to satisfy withdrawals. Also referring to deposit
concentration risk.
 Eg.
LIQUIDITY RISK
Asset
Liquidity Risk
Deposit
Liquidity Risk
Unable to execute transactions
at the prevailing market price
because there is no market
appetite for the product.
Overdependence on Corporate
Deposits .
Overall cost of deposits
increases since corporates
always demand higher rate of
deposits on GIA.
Inabiilty to dispose of the asset
due to Shariah issues such as
prohibitions of bay al-dayn (sale
of debt)at discount.
When an Islamic bank is overly dependent on
corporate deposits, withdrawals due to maturities
will create severe asset-liability mismatches. Cost
overrun when the bank acquires funds from more
costly money market sources such as Negotiable
Islamic instruments (NII).
Operational risk
 Potential loss resulting from inadequate systems,
management failure, faulty controls, fraud and human error.
 Call for Board oversight to reduce operational risk.
Legal risk
 Legal risks becomes apparent when a counterparty or an
investor, losses money on a transaction and decides to sue the
Islamic bank to avoid meeting its obligation.
 Case in Malaysia: Datok Nik Vs BIMB
 In this way legal risk is synonymous with shariah risk
Shariah Risk
• Potential loss to the bank arising from cost of litigations
against the bank as result of contract invalidation through the
court of law.
• Shariah risk can be avoided by attending to:
1. Financial reporting requirement
2. Legal documentation requirement
3. Maqasid-Shariah requirement.
Shariah risk in Islamic Financial
Instruments
 Financial reporting: prior to PSA, bank must hold ownership of asset. Recorded
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•
•
•
•
•
•
as fixed asset.
Legal documentation: transfer of ownership from bank to customer. Warranties.
Maqasid approach: benefits outweigh the disbenefits.
Losses arising from money paid by Islamic bank to customers when contracts
were found invalid in favour of customers.
Form over substance.
Contracts and legal documentation are not consistent.
Eg. Sale with no transfer of ownership title.
Sale without warranties
Purchase undertakings in Musharakah sukuk.
Shariah risk
 Shariah risk is the potential loss to the Islamic bank arising
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from cost of civil actions carried or absorbed by the bank
from lawsuits by customers. The cost of the civil actions may
include:
Compensations and damages paid to customers
Returning profit collected from the Islamic facility
Cost of court proceedings
Reputation risk.
Shariah Risk
 There are two aspects of financial transaction involving
Islamic banking business, namely:
 The concept of the transaction: This concerns whether the
contract is based on sale, ijarah, wakalah, musharakah and other
common contracts in Islamic banking, where the pillars of
‘aqd are central.
 The legal documentation of the transaction that spelt out the
rights, responsibilities and obligations of the contracting
parties. In essence, it defines the relationship between the
bank and the customer. Usually the documentation is based
on civil law.

Shariah Compliance: Consistency is Critical
to avoid Shariah risk
‘AQAD
Principles
LEGAL/CONTRACT
DOCUMENTATION
Protection of Rights
MAQASID
Benefits vs disbenefits
FINANCIAL
REPORTING
AAOIFI/IFSB/IFRS
Shariah Compliant Parameters
• Aqad-based – Contract-based
• Maqasid al-Shariah (purpose of the Law) – impact on
society
• Financial Reporting – actual strength and performance of
companies
• Legal documentation – identification and recognition of
rights and obligations of contracting parties.
Approved Islamic Finance Products
• BBA Home Financing
• Bay Inah Home Financing
• Bay Inah Personal Financing/Overdraft/credit card
• Tawaruk munazam personal financing
• Commodity murabaha
• Ijarah thumma al-bay
• Bai-bithaman Ajil Islamic Debt Securities (BAIDS)
• Discounted Bay al-dayn MuNif
• Sukuk Ijarah
• Sukuk Musharakah
Challenging issues in AQAD-based Islamic
Finance Products
• Benchmaking profit rate against interest rate (LIBOR,KLIBOR).
• Profit Equalization Reserve (PER) – displaced commercial risk
• Sale with condition to buyback at predetermined price between
•
•
•
•
•
•
•
two and three parties.
Profit generated over installment payments – time value of money
Penalties on delayed payments
Benchmaking sukuk rates against LIBOR
Musharakah with Purchase undertakings – fixed profit to one
party only.
Ijarah Sukuk - Sale with repurchase agreement at par value
and not mark-to market
Ijarah Sukuk – Ownership of asset by SPV
Profit-rate swaps – speculation or gambling?
#1 AQAD Method
Aqad
Agents of
Contract
Objective
of Contract
Subject
Matter
Offer &
Acceptance
Sale (Al-Bay’)
Buyer & Seller
Transfer of
Ownership from
Buyer to Seller
Property
Price set on the
spot
Contract of Sale
•
Example: Murabaha/BBA Sale
1.
Buyer and Seller
eg. Seller owns asset/subject matter before making sale
Subject matter
eg. Mal mutaqawim – property with usurfruct
Price
eg. Set on the spot
Offer & Acceptance
eg.Verbal or in writing
2.
3.
4.
Method #2: Maqasid al-Shariah/Objective of
Shariah
To protect the interest of the public (society)- maslahah al-ammah
by:
1. removing the harm ( ibqa)
2. securing of benefits (tahsil)
#2 Maqasid Method
Maqasid
Shariah
Removing
the Harm
Securing
of Benefit
Objective of Shariah
Islamic financial products as defined by AQAD methodology,
should contain more benefits (masalih) and less or no harm
(madarah).
“ in gambling (maisir) and liqour (qimar), there are some sins and some
profits. But the sins are greater than the profits” (Al-Baqarah: 168).
“ in Gambling (maisir) and Liqour (qimar),
there are some sins and some profits. But
the sins are greater than the profits” (AlBaqarah: 168).
Mudarat
Sins
Manfaat
Profits
Mudarat
Riba
Manfaat
Mudarat
Manfaat
Mudarat?
Financing
BBA
Manfaat?
Mudarat?
Manfaat?
Mudarat >
Manfaat
HARAM
Mudarat <
Manfaat
HALAL
Downside (Madarrah) of Credit-Financing
MACRO
MICRO
Economic Bubbles
Bankruptcy
Subprime Loans
Foreclosure
Financial Turmoil
Unemployment
The upside (Manfaat) of Credit-Financing
MACRO
MICRO
Allocation of Capital
Wealth creation
Economic Growth
Rich becoming richer
Leisure, luxury and lifestyle
Maqasid

1.
2.
3.
4.
To analyse(theoretical) and measure( empirical) impacts of
financial intermediation based on aqad-based Shariah
compliant products.
Efficiency studies
Profitability studies
Studies on Consumer welfare and protection
Studies on Financial stability
Maqasid – protecting public interest.
 Aqad-based products (ABP) SHOULD contain more benefits and less harm.
 What if, it was proven than they (ABP) contain more harm than good?
eg. Abandon projects – customer cannot make recourse against bank as
selling party?
Defaulted BBA customer are required to make settlement based on the
selling price.
Sale with no transfer of ownership.
Giving away clean inah personal financing at high profit rates– a way
towards subprime inah?
Conflict between Aqad and Maqasid?
Method #3: Financial Reporting
 Proper recording of transactions to evident TRUE SALE.
 BBA – bank must put BBA asset on balance sheet prior to
sale. I week, 1 month it depends.
 Once sold, it is recorded as BBA receivables.
 AITAB assets should be on banking book as leasing assets but
now treated as “financing and advances”.
 External auditors (PWC, KPMG etc.) are not required by
the authority to conduct Shariah audit. And they may not be
not capable to do so.
Conflict between AQAD and financial reporting?
Islamic Bank Average Balance Sheet
Assets
Liabilities
Murabaha/BBA
Wadiah Dhamanah deposits
AITAB
Profit Sharing Investment Acct
Islamic Securities/Sukuk
Capital
1st October 2008
Assets
Liabilities
FIXED ASSET
1. BBA asset
15 October 2008
Assets
Liabilities
CURRENT ASSET
2. BBA Receivables
1. 1/9/2008 Bank purchases Property from Vendor
for $200,000
1. 15/9/2008 Bank Sells Property to Customer for
$280,000
‘Do not Sell what you don not Own”
Hadith (Sahih Bukhari)
High Court Judge Datuk Abdul Wahab Patail says that the
sale element in BBA sale is not a bona fide sale (Mayban Finance vs Taman Jaya)
BBA Legal Documentation
1.
2.
3.
4.
Sale and Purchase Agreement (SPA)
Property Purchase Agreement (PPA)
Property Sale Agreement (PSA)
Deeds of assignment/Charge
1. No transfer of title from Customer to Bank
2. Bank do not have
legal + beneficial ownership
of property to make a valid sale
Method #4: Legal Documentation
 BBA should be documented as a true sale and not as a loan.
(Dato’ Nik vs. BIMB)
 Ijarah should be documented as operating lease and not a
loan (Tinta Press vs. BIMB)
 Islamic bank has not practice fairness compared with
conventional bank (Affin bank vs Zulkifli).
Conflict between AQAD and documentation of AQAD?
‘Do not Sell what you don not Own”
Hadith (Sahih Bukhari)
High Court Judge Datuk Abdul Wahab Patail says that the
sale element in BBA sale is not a bona fide sale
BBA Legal Documentation
1.
2.
3.
4.
Sale and Purchase Agreement (SPA)
Property Purchase Agreement (PPA)
Property Sale Agreement (PSA)
Deeds of assignment/Charge
1. No transfer of title from Customer to Bank
2. Bank do not have
legal + beneficial ownership
of property to make a valid sale
Shariah Compliance: Consistency is Critical
‘AQAD
Principles
LEGAL/CONTRACT
DOCUMENTATION
Protection of Rights
MAQASID
Benefits vs disbenefits
FINANCIAL
REPORTING
AAOIFI/IFSB/IFRS
Risk Measurement
 Credit risk –banking book
Credit scoring, Stress Testing, non-performing financing
(NPF)
 Market risk –trading book
VaR
 Market risk – banking book
Deposit-Asset mismatch,Gap, Duration models
VaR: a measure for market risk
Market Risk:Trading Book
Value at Risk (VaR)
 Bank purchases securities for both holding and trading.
 For holding, the securities are recorded in the banking book.
Potential loss in the banking book is measured by Earning at
Risk (EAR)
 For trading, the securities are recorded in the trading book.
Potential loss in the trading book is measured by Value at Risk
(VaR)
Bond Trading
 Bond Price = Coupon / interest rates
Price = $1000 per unit
i= 10%
Coupon = $100
$1000 = $100/0.1
 An investors is deciding whether to purchase bond or not.
 He will only buy bond in order to make capital gain. Thus, he must buy low and sell
high.
 If he expects, interest rate to increase, he will not buy the bond. This is because the bond
price will fall and he losses out. Example:
Buy at $1000. When interest rate increases to 20%, bond price will fall; $500 =
$100/0.2. He buys at $1000 per unit and now the bond market value at $500. Loss =
$500.
 VaR – what is the maximum loss the investor can absorb?
Bond Trading
 Bond Price = Coupon / interest rates
Price = $1000 per unit
i= 10%
Coupon = $100
$1000 = $100/0.1
 An investors is deciding whether to purchase bond or not.
 He will only buy bond in order to make capital gain. Thus, he must buy low and sell
high.
 If he expects interest rate to fall, he will buy the bond. This is because he will make profit
since the bond price now increases. Example.
$1000 = $100/0.1. When interest rate indeed fall down, say to 5%, bond price will
increase to $2000. He will make a capital gain of $1000.
$2000 = $100/0.05.
VaR
 The senior management is told that there is 1 in 100,
say, chance of losing X dollars over the holding period.
 It means that there is a 1% chance that the bank will lose
$50 million over 1 year.
 Var = $50m at 95% confidence interval implies that
there a 5% possibility that the bank may lose $50m.
VaR

1.
2.
3.
A VAR statistic has three components:
a time period,
a confidence level and
a loss amount (or loss percentage).
 Keep these three parts in mind as we give some examples of variations of the
question that VAR answers:
 What is the most I can - with a 95% or 99% level of confidence - expect to lose in
dollars over the next month?
 What is the maximum percentage I can - with 95% or 99% confidence - expect to
lose over the next year?
 You can see how the "VAR question" has three elements: a relatively high level of
confidence (typically either 95% or 99%), a time period (a day, a month or a year)
and an estimate of investment loss (expressed either in dollar or percentage terms).
Value at Risk (VaR)
VaR is potential loss
VaR is the “maximum loss” at a preset confidence interval
Confidence interval reflects the risk appetite of the bank
Confidence interval is also the probability that the loss exceed capital of the
bank, triggering bank insolvency.
 Confidence interval is equivalent to the default probability of the bank.
 VaR shines for 3 main reasons:
1. it provides a complete view of portfolio risk
2. it is the basis of measuring economic capital
3. VaR assigns a dollar value to risk




VaR and Its Application
 Senior management is told that there is 1 in 100, say, chance of losing X dollars
over the holding period.
 There is a 1% chance that the bank will lose $50 million over 1 year.
 VaR= $50m at 99% confidence interval implies that there a 1% possibility that
the bank may lose $50m.
 VaR is potential loss, thus when a VaR limit become binding, it will put pressure
on the bank’s trading business to lower their risks.
 For example, the trading book = $200 billion and the VaR is $40 million. It
means that there is 1% possibility that the bank may lose $40m from the trading
book valued at $200 billion.
 Usually, if the economy gets worse, VaR limit will be lowered.
Estimating VaR
Variancecovariance
Risk factors can
be correlated
The historical
simulation
Risk factors
based on past
events
Monte Carlo
simulation
Risk factors as
random
Stress Test: Serves to complement
VaR
 VaR is used to provide a probabilistic prediction on losses that are





likely to happen for a pre-specific holding period and confidence
level.
It is difficult to ensure that by using Var, extreme cases are fully
covered.
The purpose of stress testing is to determine the size of potential
loss related to specific scenarios or extreme cases.
The selection of scenarios is largely based on expert judgment.
Stress testing show us how vulnerable a portfolio might be to a
variety of extreme events.
Stress testing can be conducted on stand alone basis ie. without
VaR.
Stress testing
 ST is a standard risk management technique used to identify
and quantify possible events of future changes in the financial
and economic conditions that could have unfavourable effects
on the Bank’s exposure.
 Conceptually, a ST is an approach to revalue a portfolio using
different set of assumptions.
 The objective is to better understand the sensitivity of the
portfolio to changes in various risk factors.
 This change is often expressed in terms of impact on some
measure of bank earning, profitability and asset quality to
understand its sensitivity to the risk factors being considered.
Actual
Stress Test
Baseline
Stress Test
Plausible
Stress Test
Worse
$48b
$40b
$35b
P&L
Capital Base $50b
RWA
RWCR
15%
13%
11%
9%
NPF
7%
8%
9%
11%
Stress Test
Worse
case risk
factors
High
NPL
Low
Profit
Slow
capital
growth
Risk-Factors
GDP
CPI
BLR
Unemployment rate
Retail Index
Property Index
Sensitivity
tests
Stress
Test
Scenario
tests
Sensitivity Tests
 Instead of doing financial projection on a "best estimate" basis, a company may
do stress testing on capital, NPF etc. where they look at how robust a financial
instrument is in certain crashes. They may test the instrument under, for
example, the following stresses:
 What happens if the market crashes by more than x% this year?
 What happens if interest rates go up by at least y%?
 What if half the instruments in the portfolio terminate their contacts in the
5th year?
 What happens if oil prices rise by 200%?
Sensitivity test
Asses the impact of
large movements in
financial variables on
portfolio without
specifying the reasons
for such movements
Example
10% drop on the stock
market indexes
Scenario
Tests
Constructed in the light of
historical events or in the
contexts of a specific
portfolio
Eg. Large US stock market
decline 1987, Asian
financial crises 1997,
Russion default 1998,
September 11 2001
Stress Test : How can changes in economic fundamentals
affect bank’s capital?
Changes in
interest
rates
Changes in
commodity
prices
Extreme
Scenarios
Changes in
Equity
prices
Changes in
exchange
rates
Stress Test Credit Risk
The
Baseline
case
Stress Test
Credit
Risk
2%
increase
in NPL
1%
increase
in NPL
Adverse
macroeconomic
scenarios
Bank
Failure
Credit
Crunch
Client
Default
Capital
Erosion
Recession
Credit
Loss
Bank Loss
What’s Next?
Financial Stability: Bank Capital
Requirement
Basel II
Shariah Framework
Islamic Banking
Bank Negara Shariah
Supervisory Board
AAOIFI
Fiqh Academy
Regulatory Framework
Islamic banking
Basel II
Islamic Financial
Service Board
Basel II
Minimum Capital
Requirement
1.
2.
Standardized Based
Approach
Internal Based
Rating Approach
Supervisory
Review
Market Discipline
Basel II

The objective of Basel II is to protect depositors’ fund through an international standard
concerning how much capital banks need to put aside to guard against losses arising from exposures
to risks. This is done by establishing rigorous risk and capital management requirements designed to
see that the bank holds sufficient capital reserves appropriate to the risk it is carrying through its
lending and investment practices. Hence, the more the bank is exposed to risk, the greater is the
amount of capital the bank needed to back up the assets. The three pillars if Basel II is shown in the
following diagram:
3 Pillars of Basel II

Minimum capital Requirement

Supervisory Review

Market Discipline
Basel II
• The objective of Basel is to protect the depositors
since deposits mobilization is based on creditordebtor contract.
• Loss due to default affects Bank’s capital
• Insufficient bank’s capital leads to bank runs and
foreclosure – financial instability.
• Thus, bank must hold sufficient capital as a back
up to the amount of money they owe depositors
Basel II
• Capital Adequacy Ratio (minimum = 8%)
Ratio
Total
Capital
Risk-Weights
• CAR = Total Capital / (Credit risk + Market
risk + Operational Risk)
• Risk weight assets are the sum of asset subject
to market, credit and operational risk.
Pillar 1: Capital Requirement

The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a
bank faces:
1. credit risk – potential loss arising from non-performing loans and bad debts
2.operational risk – potential loss arising from system and human error in running banking operation
3. market risk. – potential loss caused by market volatilities that may erode value of investment in securities.
4. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely:
A) Standardized Approach: The risk-weights are based on available external credit ratings, say set by the regulatory
authority or rating agencies.
B)Foundation Internal Rating-Based Approach (IRB): The risk-weights set by the bank (i.e PD) and
LGPD set by the regulators.
C) Advanced Internal Rating-Based Approach (IRB)

For operational risk, there are three different approaches - basic indicator approach or BIA,
standardized approach or TSA, and advanced measurement approach or AMA.

For market risk the preferred approach is VaR (value at risk).
Capital Requirement

The capital requirement is a bank regulation, which sets a framework on how banks and
depository institutions must handle their capital.

The categorization of assets and capital is highly standardized so that it can be risk weighted.
Internationally, the Basel Committee on Banking Supervision housed at the Bank for International
Settlements influence each country's banking capital requirements. In 1988, the Committee
decided to introduce a capital measurement system commonly referred to as the Basel Capital
Accords (Basel Accord).

This framework is now being replaced by a new and significantly more complex capital adequacy
framework commonly known as Basel II. While Basel II significantly alters the calculation of the risk
weights, it leaves alone the calculation of the capital. The capital ratio is the percentage of a bank's
capital to its risk-weighted assets.

Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant
Accord
.
Determination of Capital Requirement in Basel II
Commercial Banks
Standardized Rating
Based Banks
Risk weights sets by
regulators and external
credit rating agencies
Internal Rating Based
Banks
Risk-weights sets by
Bank and Regulator
Capital Requirement
 Tier 1 capital is the core measure of a bank's financial
strength from a regulator's point of view. It consists primarily
of 1) shareholders' equity but may also include preferred
stock that is irredeemable and non-cumulative and 2)
retained earnings.
Pillar 2 : Supervisory Review
 The second pillar deals with the regulatory response to the
first pillar, giving regulators much improved 'tools' over
those available to them under Basel I. It also provides a
framework for dealing with all the other risks a bank may
face, such as systemic risk, pension risk, concentration risk,
strategic risk, reputation risk, liquidity risk and legal risk,
which the accord combines under the title of residual risk.It
gives bank a power to review their risk management system.
Pillar 3: Market Discipline
 The third pillar greatly increases the disclosures that the bank
must make through regular financial reporting to the bank
supervisors. This is designed to allow the market to have a
better picture of the overall risk position of the bank and to
allow the counterparties of the bank to price and deal
appropriately.
Impact of Basel II on Islamic Banking
Capital Requirement
Uneven Playing Field
Standardized Approach:
Conventional Bank
Assets
Amount
Loans
Hire-Purchase
Personal Loans
Bond
$600m
$300m
$200m
$100m
TOTAL
$1200
Riskweights
50%
50%
100%
50%
RWassets
$300
$150
$200
$ 50
$700
Capital ratio = (Regulated Capital / RWA)
8% = RC / $700
RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5)]
= $300m + $150m +$200m + $50m = $700
RC = $700 x 0.08 = $56m
Note Risk weight also known as conversion factor.
Risk-weights set by external rating institutions and regulators.
Standardized Approach:
Conventional Bank : Exercise 1
Assets
Amount
Riskweights
Loans
Hire-Purchase
Personal Loans
Bond
$ 1200m
$600m
$300m
$200m
50%
50%
100%
50%
TOTAL
$1200
RWassets
$
$
$
$
$
Capital ratio = (Regulated Capital / RWA)
8% = RC / $700
RWA = [($1200m x 0.5) + ($600m x 0.5) + ($300m x 1.00) + ($200 x 0.5)]
=$
RC =
Note Risk weight also known as conversion factor.
Risk-weights set by external rating institutions and regulators.
Islamic Bank Under Basel 2: Higher Capital
Requirement
Assets
Amount
Murabaha
AITAB
Personal F
Sukuk
$600m
$300m
$200m
$100m
TOTAL
$1200
Riskweights
50%
50%
100%
50%
RWassets
$300
$150
$200
$ 50
$700
Capital ratio = (Regulated Capital / RWA)
8% = RC / $700
RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5)]
= $300m + $150m +$200m + $50m = $700
RC = $700 x 0.08 = $56m
Note Risk weight also known as conversion factor.
Islamic Bank with Musharakah financing under
Basel 2: Higher Capital Requirement
Assets
Amount
Murabaha
AITAB
Personal F
Sukuk
Musharakah
TOTAL
$500m
$300m
$200m
$100m
$100m
$1200
Riskweights
50%
50%
100%
50%
250%
RWassets
$250
$150
$200
$ 50
$250
$900
Capital ratio = (Regulated Capital / RWA)
8% = RC / $900
RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5) + ($100 x 2.5)]
= $250m + $150m +$200m + $70m + $250 = $900
RC = $900 x 0.08 = $72.00m
Note Risk weight also known as conversion factor.
Stress on Islamic bank capital
 Since the risk-weight for Musharakah is 250%, the bank is charged




higher capital from $56m to $78m. The bank has to come up with
$22m more capital to meet regulator’s requirement in order to
undertake the Musharakah project.
In this sense, the Musharakah project places stress of Islamic bank
capital.
Basel II assumes that Islamic deposits are similar with conventional
deposits.
In conventional deposits, the deposits and interest income are
guaranteed.
This is not the case for Islamic deposits since they are based on
profit-sharing system. In this manner, the bank need not provide
capital guarantees.
Bank Negara Malaysia (BNM) Guidelines on Profit-Sharing Investment
Account (PSIA) with risk absorbent
 In order to highlight the more accurate nature of mudarabah deposits (PSIA) and its
impact on bank capital, BNM has provided a new formulation for determining regulated
for Islamic banks.
 PSIA will be used to finance a relatively more risky projects based on mudarabah, istisna
and musharakah contracts.
 The formulation capital adequacy ratio (CAR) = Capital/ (RWA less (1-α)RWA funded
by PSIA less (α)RWA in the form of PER)
 When α = 1, the bank holds all risks in the balance sheet.
 When α is say 30%, the bank carry risks only from wadiah dhamanah deposits and general
mudarabah deposits.
 Then 70% of the risks (1-α) = (1-0.3), is carried by PSIA deposits.
 Then CAR will be less than CAR without α as a risk-absorbent factor. This will reduce
stress on Islamic banking capital.
 Hence, the smaller the α i.e. the more risks carried by PSIA, the lower is the CAR.
Modified Formula Incorporating the Risk
nature of Mudarabah Deposits
 RWCAR Islamic = [Capital Base] /[(TRWAIslamic)
Less
(1-) (Credit and Market Risk Weighted Asset
funded by PSIA)
Less
()(proportional of Credit and Market Risk
Weighted Assets funded by PSIA in the form of PER)]
Islamic Bank with Musharakah financing under
Basel 2: Higher Capital Requirement
Assets
Amount
Murabaha
AITAB
Personal F
Sukuk
Musharakah
TOTAL
$500m
$300m
$200m
$100m
$100m
$1200
Riskweights
50%
50%
100%
50%
250%
RWassets
$250
$150
$200
$ 50
$250
$900
Capital ratio = (Regulated Capital /( RWA – [1-α]RWA funded by PSIA –[α] RWA funded by PSIA as PER)
1.α= 30%
2.(1-α) = 70%
3.RWA funded by PSIA = $250m (musharaka)
4.RWA as PER = $2m (by assumption)
RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5) + ($100 x 2.5)]
= [$250m + $150m +$200m + $70m + $250] - (0.7)($250) – (0.3)($2) = $900m - $175m - $0.6m = $724.4m
RC = $724.4 x 0.08 = $57.95m
Note Risk weight also known as conversion factor.
PER = Profit Equalization Reserve.
 (1-) represents the quantum of PSIA recognized as a risk
absorbent for RWCR computation purposes and approved by
Bank Negara Malaysia.
  = 1 means all risks carried by bank
  = 0 means all risks carried by PSIA.
The smaller the , the lower is RWCR.
Corporate Governance and Risk Management:
Basel II Pillar 3 on Market Discipline
Scandals and failure of energy giant Enron,
WoldCom and Global Crossing and now the
Subprime Banking crises in the USA that saw the
fall of giant Lehman,Morgan Stanley,AIG etc.
Basel II Pillar 3
 Aims at strengthening market discipline, i.e the pressure that
financial markets may exert on bank managers so as to
promote safe and sound bank management.
 Pillar 3 defines a number of disclosures requirements aimed
at increasing the transparency of each bank’s risk profile and
risk policy.
Corporate Governance
 Boards were provided with misleading information
 Breakdown in the process by which information was




transmitted to the board and shareholders.
Breakdown involving financial engineering and nondisclosure
of economic risks
Outright fraud.
Regulatory authorities must upgrade work to protect all
stakeholders.
Legislations to mend perceived failures in corporate
governance practices.
Board and Corporate Governance
 The primary responsibility of the board is to ensure that it
develops a clear understanding of the bank’s business strategy
and the fundamental risks and rewards it implies.
 The board must make sure that risks are transparent to
managers and to stakeholders through adequate internal and
external disclosure
 The board must characterize an appropriate “risk-appetite”
for the firm.
Business Strategy, Board and Risk Management
1.
2.
3.
4.
Avoid risk by choosing not to undertake some activities.
Transfer risk to third parties through insurance, hedging and outsourcing, subject to
Shariah rules.
Mitigate risk such as operational risk, through preventive and detective control
measures.
Accept risk, recognizing that undertaking certain risky activities should generate
shareholder value.

Board should ensure that business and risk management strategies are directed at
economic rather than accounting performance.

Board must make sure that the bank has put in place an effective risk management
program that is consistent with these fundamental strategic and risk appetite choices.

It must make sure that there are effective procedures in place for identifying, assessing
and managing all types of risk ie. business risk, operational risk, market risk, liquidity
risk, credit risk, shariah risk, rate of return risk and displaced commercial risks.
Basel II and IFSB
 High risk-weights for Musharakah Financing to imply that
bank bears business risk and the general investment account
holders (GIA) do not.
 Recent PSIA guidelines will test risk appetite of depositors.
Limits and Limits Standard
Policies.
 Market-risk limits serve to control the risk that arises from
changes in the absolute price (or rate) of an asset.
 Credit risk limits serve to control and limit the number of defaults
as well as limiting a downward migration in the quality of the
credit portfolio.
 It is best practice for institutions to set down on paper the process
by which they establish risk limits, review risk exposures, and
approve limit exceptions and to develop an analytical methodology
used to calculate the bank’s risk exposures.
 For many banks, best practice risk governance will call for the
development and implementation of sophisticated risk metrics
such as value at risk (VaR) measures for market and credit risk.
I
CIFP2 IB2002 Risk Management for
Islamic Financial Institutions
ISLAMIC FINANCIAL SERVICES BOARD (IFSB)
STANDARDS
I
GUIDING PRINCIPLES OF RISK MANAGEMENT
FOR INSTITUTIONS
(OTHER THAN INSURANCE INSTITUTIONS)
OFFERING ONLY ISLAMIC FINANCIAL SERVICES (IIFS)
December 2005
Principle 1.0
:
IIFS shall have in place a comprehensive risk management
and reporting process, including
i)
appropriate board and senior management oversight,
ii)
to identify, measure, monitor, report and control relevant
categories of risks and, where
iii)
appropriate steps to comply with Shariah rules and
principles and
iv)
to ensure the adequacy of relevant risk reporting to the
supervisory authority.
Principle 2.1
: IIFS shall have in place a strategy for financing, using
various instruments in compliance with Shariah,
whereby it recognises the potential credit exposure
that may arise at different stages of the various
financing agreements.
 Principle 2.2
:
IIFS shall carry out a due diligence review in
respect of counterparties prior to deciding on the
choice of an appropriate Islamic financing
instrument.
IFSB Credit Risk
 Principle 2.3
IIFS shall have in place appropriate
methodologies for measuring and
reporting the credit risk exposure arising
under each Islamic financing instrument.
IFSB Credit Risk
 Principle 2.4
IIFS shall have in place Shariah compliant
credit risk mitigating techniques appropriate
for each Islamic financing instrument.
CAPITAL ADEQUACY STANDARDS
(CAS)
KEY OBJECTIVES OF CAS
Sets out a common structure for the assessment of Islamic Institutions Offering
Financial Services (IIFS) capital adequacy requirements, which will support
transparency and consistent methodology for all IIFS.
A common approach without compromising Shariah rules and principles by
substantially enhancing the transparency of true obligations within IIFS
operations.
Promotes a level playing field at a global level as far as common assessment is
concerned especially for the minimum capital requirements in respect of both
credit and market risks arising from each financing mode at different stages of a
contract.
Recognition of investment account holders account holders (IAH) as partners in
IIFS operations should result in a more effective use of capital.
To ensure that Islamic banks can absorb a reasonable level of
losses before becoming insolvent.
To provide protection to depositors and/ or PSIA – the higher
the CAR, the higher the level of protection.
To promote stability and efficiency of the financial system by
reducing the likelihood of Islamic banks become insolvent.
To
ensure
that
the
Islamic
banks’
capital
commensurate with its overall risk profile and strategy.
position
GENERAL PRINCIPLES OF CAS
IIFS are required to use the substance of the Shariah rules and
principles governing the contracts to form the basis for an
appropriate
treatment in
deriving
their minimum
capital
adequacy requirements.
Capital
adequacy
requirements
vary
according
transformation of risks at different contract stages.
to
the
On basis of either Mudarabah or Wakalah contract, credit and market
risks of the investment made by the IAH shall normally be borne by
themselves, while the operational risk is borne solely by the IIFS (unless
proven negligence, mismanagement or fraud).
Credit risk is measured according to the Standardised Approach of Basel II,
except for certain exposures arising from investments by means of
Musharakah or Mudarabah contracts in assets that are not held for trading.
Until adequate historical data are available, the IFSB employs Basel’s risk
weights.
Apart from market risk exposures arising from equity, foreign exchange,
commodities, the exposures also include trading positions in sukuk and
inventory risk, which results from IIFS holding assets with a view to re
selling or leasing them.
In the case of equity investment made by means of Musharakah or
Mudarabah contract where the underlying assets are commodities
held for trading, market risk provisions for commodities are applicable.
For inventory risk, only simplified approach is applicable.
Shari’ah noncompliance risk is a type of operational risk facing the
IIFS which can lead to non recognition income and resultant
losses.
The extent of losses from non compliance with Shariah rules and
principles cannot be ascertained owing to lack of data.
 Supervisory authorities have discretion to impose a RW higher
than 15% as they deem fit to cater for the Shari’ah
noncompliance risk of a particular IIFS.
GUIDING PRINCIPLES ON CORPORATE GOVERNANCE FOR
INSTITUTIONS OFFERING ONLY ISLAMIC FINANCIAL SERVICES
(EXCLUDING ISLAMIC INSURANCE (TAKAFUL) INSTITUTIONS
(IIFS)
AND ISLAMIC MUTUAL FUNDS)
Principle 1.1
: IIFS
shall
establish
a
comprehensive
governance
policy framework which sets out
the strategic roles and functions of
each organ of governance and
mechanisms for balancing the
IIFS’s accountabilities to various
stakeholders.
IFSB Guiding Principles on Corporate
Governance
 Principle 1.2
IIFS shall ensure that the reporting of their
financial and non-financial information meets
the requirements of internationally
recognised accounting standards which are
in compliance with Shariah rules and
principles and are applicable to the Islamic
financial services industry as recognised by
the supervisory authorities of the country.
Principle 2.1
: IIFS shall acknowledge IAHs’
right to monitor the performance
of their investments and the
associated risks, and put into
place adequate means to ensure
that these rights are observed
and exercised.
Principle 2.2
: IIFS shall adopt a sound investment
strategy which is appropriately aligned
to the risk and return expectations of IAH
(bearing in mind the distinction between
restricted and unrestricted IAH, and be
transparent in smoothing any returns.
Principle 3.1
:IIFS shall have in place an appropriate
mechanism for obtaining rulings from
Shariah scholars, applying fatawa and
monitoring Shariah compliance in all
aspects of their products, operations
and activities.
Principle 3.2
:
IIFS shall comply with the Shariah rules and
principles as expressed in the rulings of the
IIFS’s Shariah scholars. The IIFS shall make
these rulings available to the public
Part 4 : Transparency of Financial Reporting
in respectof Investment Accounts
Principle 4
:
IIFS shall make adequate and timely
disclosure to IAH and the public of material
and relevant information on the investment
accounts that they manage.
Thank You
Best wishes on your examination