Risk Issues for Islamic
Banks
Global Islamic Finance Forum
18 September 2012
Strictly Private & Confidential
Questions to be addressed
1) Is the Risk Management Approach in Islamic Banks different from
Conventional Banks?
2) What are some of the main specific risk issues Islamic Banks face?
3) How can these be best mitigated?
4) How to find the optimal risk/return within a defined Risk Appetite
Framework?
5) Your Questions
Page 2
Risk Management Approach in Islamic Banks
Different from Conventional Banks?
- Governance
- Framework (COSO)
- Risk Culture
- Systemic Risk in
Islamic Banking?
Page 3
Generic Risks In Islamic Banking
Credit Risk
-Debt based versus Equity based
-Loss given Default higher
-Transfer of credit risks to Investment Account Holders
-Contract Risk
-Limited Data for effective application scoring
Page 4
Generic Risks In Islamic Banking
Market Risk
-Limited hedging instruments
-Liquidity issues
-Valuation
-Shifting of risk from market to credit and back
Page 5
Generic Risks In Islamic Banking
Operational Risk
-Complexity higher
-Limited knowledge of staff
-Processes
-Systems
Page 6
Specific Risks in Islamic Banking
-Shariah Non-Compliance risk
-Displaced Commercial Risk
-Asset & Liability Gap Risk
-Equity Investment Risk
Page 7
Typical Balance Sheet
ASSETS
LIABILITIES
Retail Financing
Restricted Investment Account Holders
Corporate Commercial Financing
Unrestricted Investment Account Holders
Equity Based Financings / Partnerships
Profit Sharing Investment Accounts
Investments (Sukuk)
Demand Deposits
Shareholders
Equity Investment
Risk
Displaced
Commercial Risk
Rate of Return Risk
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Specific Risks in Islamic Banking
Displaced Commercial Risk
“The risk arising from assets managed on behalf of Investment
Account Holders which is effectively transferred to the Islamic
Financial Institution’s own capital because the Institution forgoes
part or all of its Mudarib’s share on such fund, when it considers
this necessary as a result of commercial pressure in order to
increase the return that would otherwise be payable to the
Investment Account Holder.” IFSB(2005)
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Specific Risks in Islamic Banking
Displaced Commercial Risk
Dual Banking Environment
Commercial pressure
Due to GIA/SIA
Return not guaranteed
Bank’s share of profit
From equity or reserve
Relationship
From borrower/lender to partner
Operational Risk
Fiduciary risk absorbed by Bank
Page 10
Profit Equalization Reserve & Investment Risk Reserve
Sources of Funds
Investment
Accounts
Shareholders Funds
Assets
Fund Allocation
PER
Profit & Loss
Profit/Loss
Profit
Loss
IRR
Profit & Loss
Distribution
Bank
Bank
IAH
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Specific Risks In Islamic Banking
Displaced Commercial Risk - Issues
-Non standardized practices across jurisdictions: non transparent
-Conflict of interest between shareholders and IAH. Rate of return paid
to IAH is ‘smoothed’ at expense of shareholders
-But in case of PER, this could also be used to increase shareholder
dividend if desired….
-Inter-generational problem
-Appearance of steady low risk returns: false performance impression
-Might increase management’s risk appetite
-Blurring key distinction between conventional and Islamic Banking
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Specific Risks In Islamic Banking
Asset & Liability Gap Risk
-Up to 4 times larger on average than at Conventional Bank
-Long (fixed) Assets versus Short (Floating) Liabilities
-Hedging issues
-But gap rapidly closing
-Innovative floating rate products
-Profit Sharing Investment Accounts
(Risk Absorbent)
Page 13
Risk/Return within Set Risk Appetite
Risk Appetite
-Annually, approved by Board
-Linked to strategy and Macro Economic Environment
-Statements across various categories
-Risk Organisation & Infrastructure
-Qualitative Risk Statements
-Quantitative Statements
-Limit Structure
-Effective Communication
Originating Department
Page 14
Risk/Return within Set Risk Appetite
Internal Capital Adequacy Assessment Process (ICAAP)
Initial Capital
Assessment
Economic
Capital
Definition
Capital Supply
Internal Target
RWCR
Capital Stress
Test
Internal Capital Planning
Material Risk
Assessment
Capital Demand
Page 15
Risk Assessment
Develop comprehensive risk library
Credit Risk
Market Risk
Equity Investment
Risk/
Capital Impairment
Risk
Foreign Exchange
Risk
Funding Cost Liquidity
Risk
Commodity Risk
Credit Spread Risk
(large) Exposure Risk
Equity Risk
Profit Rate Risk
Banking Book
Default/Counterparty/P
re-settlement/Delivery
Risk
Option Risk
Profit Rate Risk
Trading Book
Credit Concentration
Risk
Inventory Risk
Country/Country
Transfer Risk
Asset/Market Liquidity
Risk
Residual/Credit
Mitigation Risk
Funding Liquidity Risk
Displaced Commercial
Risk
Migration Risk
16
Risk Assessment
Operational Risk
People Risk
Model Risk
Technology Risk
Market Driven Volume
Risk
Business Continuity
Risk
Strategic/Business
Risk
Political Risk
Reputational Risk
Regulatory/Complianc
e Risk
Process Risk
Legal Risk
Systemic Risk
Shariah Non
Compliance Risk
Fiduciary Risk
17
Materiality Assessment
For instance:
– Quantitative: Net exposure represents more than 5% of Bank’s capital for
respective Risk type
– Qualitative: Bank’s expert judgment that such risk could threaten survival
of Bank
© Jeroen Thijs 2012
18
Risk/Return within Set Risk Appetite
-In combination with 3 year dynamic stress test
-Determine minimum capital needed to support business
-Decide on capital allocation and minimum required return on capital
-ICAAP then forms basis for finding optimum risk/return
Originating Department
Page 19
Closing Thought
Is Islamic Banking Riskier than Conventional Banking?
Originating Department
Page 20
THANK YOU
jeroen@bankislam.com.my
www.bankislam.com.my
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