TK 6413 / TK 5413 :
ISLAMIC RISK
MANAGEMENT
TOPIC 2:
THE IDENTIFICATION OF RISK
EXPOSURES
1
(I) INTRODUCTION
• Usually the process of identifying the risks facing an organization is
a two-party activity i.e., an internal personnel and an external risk
specialist or consultant;
• Risk identification techniques have been developed simultaneously
by professionals from different disciplines such as:
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Production engineers;
Accountants;
Quantity surveyors;
Marketing managers;
Each group has been concerned and exposed to a somewhat
different problem, the strategies and techniques adopted
therefore for identifying the risks and hazards have also differed;
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• Risk identification by definition is the process by which an
organization is able to learn of the areas in which it is exposed to
risk; identification techniques are designed to develop
information on sources of risk, hazards, risk factors, perils and
exposure to loss;
• The task of risk identification evolves continuously; changes in
the organization and the environment require constant attention
to the identification of new risks; the organization itself changes
through means such as entry into new lines of business,
withdrawal from others, acquisition and divestiture; in addition,
the environment changes, as exemplified by evolving legal
responsibilities, changes in government mandates and
administrative rules, and changing rules of good citizenship;
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a)
Sources of Risk:
• The following are sources of risk according to the different environment set
up,
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Physical environment;
Social environment;
Legal environment;
Operational environment;
Economic environment;
Cognitive environment;
b) Identification of Exposures:
• Sources of risk are essentially of no concern to an organization unless that
organization is exposed or vulnerable to the perils that arise from those
environments; therefore, an important aspect of risk identification; four
categories of risk exposure are:
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Physical Asset Exposures;
Financial Asset Exposures;
Liability Exposures;
Human Asset Exposures;
c) Checklist Used in Risk Identification:
• A risk manager interested in identifying potential profit
opportunity will have to develop a framework in the form of
a risk checklist;
• If a fairly comprehensive checklist can be developed, the
next step is the creation of a systematic approach to
discover which of the potential losses and gains included in
the framework are faced by the organization; implicit in this
second step is the development of an identification system
that will enable the risk manager to receive information
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about risks on an ongoing basis;
• Types of checklist:
• Traditionally the risk assessment checklist have offered a
framework for identification of insurable risks;
• Such checklists are useful starting points for the development
of an overall analytical framework, but there are two important
limitations: (i) standardized checklists will fail to list risks that
are unusual or unique to a particular organization; (ii) since
traditional risk management has not been concerned with
speculative risks, the checklist is unlikely to acknowledge this
type of risk;
• Applying a checklist:
• One method of applying the checklist is to focus on possible
sources of risks; the seven sources of risk outlined earlier
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provide a good starting point;
• A similar approach advocated by John O’Connell identifies four components
of the relevant environment: (i) customers; (ii) suppliers; (iii) competitors;
and (iv) regulators;
• Supplemental Techniques:
Regardless of the method used to apply the checklist, at least nine techniques
are available to supplement the analysis; these methods include:
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the financial statement method;
the flow-chart method;
on-site inspections;
planned interactions with other departments;
interactions with outside suppliers and professional organizations;
contract analysis;
statistical analysis of loss records;
incident reports;
hazard analysis;
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d) Risk Management Information Systems:
•
To identify new risks, the risk manager needs a far-reaching information
system, which yields current information on new developments that may
give rise to risk; in addition, the risk manager needs a system of
maintaining the wide range of information that affects the organization’s
risk;
•
With the overall system, are subsytems such as:
i.
Risk Management Policy Manual:
o Depositing of all risk management corporate policies;
o Claim reporting requirements;
o Usage of companys’ assets;
ii.
Risk Management Record Systems:
o Property valuation schedules
o Vehicle and mobile equipment schedules
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o
o
o
o
o
Request for insurance bids and coverages
Insurance registers
Claim reports
Loss data
Premium and loss comparison
iii.
Risk Management Systems:
o Risk information management system database
o Support risk management decision process
o Consolidation of various form of data
o Cost of risk management administration
iv.
Internal Communication System:
o Information channels
o Introduction of new products
o Acquisition of new locations
o Progress on claims
o Information on hiring activities
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(II) OVERVIEW OF FINANCIAL RISKS
• Since all the financial entities are directly or indirectly
interwoven, interlinked, and interrelated, they create a
complicated maze of uncertainties which makes up the
mass of the financial risk;
• At the level of the enterprise, the risks can be grouped into
financial, business and operational risks; financial risks will
generally include credit, market and liquidity risk; business
risk is a combination of management and strategic risk; the
operational risk can arise due to people, processes,
systems, as well as several other factors.
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(a) Credit Risk:
• Credit risk is simply defined as the potential that a
borrower or counterparty will fail to meet its obligation in
accordance with agreed terms. This arises from the
inability of the counterparty to service the debt on the
terms agreed upon. It can also arise when the solvency or
the credit rating of the counterparty changes adversely.
• Credit risk cannot be accurately calculated before the event
since the likelihood of default is highly uncertain and this is
difficult to predict accurately.
Although there are
developments in the calculation of credit risks, the major
difficulty remains with the availability of data.
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• Relations between the Islamic counterparties and contracts and the guaranties and
collaterals are as follows :
Risk
Coverage
Guaranties,
Collaterals, etc
Islamic
Financial
Contents
Risk
Coverage
Conterparties
Agreement
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• In the structure of the Islamic financial products, counterparties
are all the parties that are involved in the Islamic contract
agreements and partnership. Thus,
• In Murabaha and Salam contracts – alongside the banks,
both the seller and buyer are considered as counterparties;
• In Ijarah contracts – the renter/lessees;
• In Istisna’a contracts – the buyer, user contractor or
manufacturer
• In musharakah & mudarabah contracts – the business
partners and agents;
• Financial institutions that provide Islamic financial products are
also exposed to credit risk because of the emphasis on lending in
the Murabaha, leasing in the Ijarah, promising to deliver or to
buy in Istisna and Salam, and investing on business performance
in the Musharakah and Mudarabah contracts.
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Islamic
Financial
Contracts
Market
Risk Coverage
Counter
party B
Guarantee A
Collateral A
25 %
Counter
party A
Risk Coverage
Counter parties
Murabaha
100%
Guaranty B
100 %
8%
72 %
Istisna
Counter
party C
5%
Collateral B
18%
30 %
5%
Collateral C
42 %
Musharakah
Strategies
95 %
Counter
party D
Collateral D
Representation of the links between a counterparty with several contracts and risk
coverage by several guaranties and collaterals
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• From the above counterparty analysis the following points
should be considered:
• The market conditions and the institutions strategies
that may influence the counterplay’s behaviour;
• The type and the volume of the contracts where the
counterplay is linked, defining also the degree of
participation;
• The links between the contracts that refer to the some
counterparty;
• The rates at the guaranties and collaterals and their
inter-links, s well as the links to the contracts and
counterparties. Note that the counterparties must be
covered by guaranties and collaterals that are rated
with a higher grade.
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• Looking from the aspects of the various Islamic financial
contracts, the Islamic financial services (IIFS) is exposed to
the following credit risks:
1) Murabahah: The IIFS is exposed to credit risk
following the exchange of the products between IIFS
and a customer. It is a settlement risk/default risk
whereby the customer may not be able to honor the
payment obligation (loss of receivables).
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(2) Salam: The IIFS is exposed to the settlement/delivery risk
where goods are not delivered, or not delivered on time,
or not according to specification by the seller/customer
after payment is made (loss of invested amount).
Another scenario is that the IIFS may not be able to
recover its capital from Salam customers fully; or claims
against urboun or a financial guarantee are not sufficient
to cover the whole amount of salam capital.
(3) Istisna: The IIFS may risk facing the customer who is
unable to honor the payment obligation for deferred
installments or progress billings (loss of amount
receivables) when the work is already in progress.
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4. Istisna’a with parallel istisna’a:
The IIFS may be exposed to completion risk in the parallel
istisna’a, when an advance payment has been made by the
IIFS and the sub-contractor does not complete the work.
The situation is greatly aggravated if no other subcontractor is available as a replacement. Such a situation
leads to risks in the direct istisna’a according to which the
IIFS has an obligation to the ultimate customer. In addition,
payments made by the IIFS to the sub-contractor may not
be recoverable.
5. Operating Ijarah and Ijarah Muntahia Bittamleek (IMB):
The customer (lessee) may be unable to service the lease
rental as and when it falls due, and thus defaults on this
obligation. In principle, the IIFS as lessor has the right to
repossess the leased asset if the lessee defaults, thus
mitigating the credit risk. However, particularly in the case
of IMB, there may be difficulties in exercising this right. 19
6. Musharakah:
The IIFS is exposed to the risk of losing its entire
invested capital in musharakah financing or investment,
since such capital may not be recovered as it ranks
lower than debt instruments upon liquidation. In
different situation, an IIFS may face a risk when a
withdrawing partner owes monies to the IIFS (loss of
invested capital).
7. Mudarabah:
The IIFS is exposed to capital impairment risk if the
venture being financed incurs losses, or if the mudarib
defaults on payments due to the mudarib.
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(b) Market Risk:
• Market risk is the of losses in on-and-off balance sheet
positions arising from movements in market prices, interest
rates, FX rates and equity values where these are the main
four market risk factors.
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• The four types of market risks that exist in the different Islamic financial products are :
Market Risk
Rate of Return
Risk
Commodity
Risk
FX rate risk
Equity Risk
Murabaha
Murabaha
Murabaha
Mudarabah
Ijarah
Salam
Ijarah
Musharakah
Salam
Istisna’a
Salam
Istisna’a
Istisna’a
Mudarabah
Musharakah
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• The IIFS are exposed to market risk in a unique manner.
The Shariah principles, to which these institutions adhere,
include the notions of materiality in transactions and the
sharing of risks and rewards. As a result, IIFS carry out
many asset-based transactions in which they take
ownership of physical assets as co-investors. This setting
exposes them to market risk-as the asset price may
fluctuate.
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• In an IIFS, market risk exposures result from:
(1).Non-binding Murabahah for the purchase order (MPO):
• If the customer cancels the agreement to purchase
(AP), the IIFS has to sell the goods in the open market
at a selling price that can be lower than the purchase
price. The IIFS may have to devote resources to
marketing efforts in order to sell the cancelled purchase
goods, or have to dispose of the asset at a loss.
Alternatively, IIFS may have to hold the goods and incur
additional costs, such as warehousing, insurance or
even damages (if goods are perishable).
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(2) Salam:
• Since salam is a forward purchase of goods, upon
signng the contract, the IIFS is exposed to price risk
on the goods, i.e. the spot price on delivery may be
lower than the amount paid.
(3) Salam with parallel salam:
• If the supplier under the saam defaults on delivery,
the IIFS may have to purchase the goods in the
open market in order to meet its delivery obligation
under parallel salam. Apart from the credit risk, the
IIFS is also exposed to price risk, as the open market
price that has to be paid may exceed the amount
paid under the slam contract.
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4. Istisna’a with parallel istisna’a:
• If the customer under a direct istisna’a defaults on the
contract and the IIFS has to find another purchaser for
the asset, it is exposed to a price risk-namely, that a
purchaser can be found only for a price lower than the
original contract price. In principle, any such loss
should be recoverable from the defaulting customer,
but such recovery may be problematic.
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(5) Operating Ijarah and Ijarah Muntahia Bittamleek (IMB):
• When the customer opts not to fulfill a non-binding
agreement to lease, and the IIFS has already acquired
the asset, it may have to lease (or sell) the asset at a
lease rental (or selling price) lower than the originally
agreed total rentals (or selling price) to the original
customer. This represents another form of price risk.
(6) Operating Ijarah:
• The IIFS will bear the potential loss due to the fair
value of the asset failing below its residual value as
estimated at lease inception (residual value risk).
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(c) Operational Risk:
• Operational risk is defined in Basel II as “the risk of loss
resulting from inadequate or failed internal processes,
people and systems or from external events including legal
risk but excluding strategic and reputational risk.
• The three major components of operational risk therefore
are people, processes, technology, or some other external
events. People’s risk include human errors, lack of
expertise, compliance and fraud. Process risks include risks
related to different aspects of running a business, which
may include regular business processes, risks related to
new products and services, inadequate/insufficient control,
etc. Failures related to systems are included in technology
risks.
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• In the context of the Islamic financial services industry,
appropriate systems, processes and products are all recent
developments. Continued growth in the industry poses a
continual challenge in these areas of development, and failures
in managing these areas will bring negative consequences.
• In the case of Islamic banks, operational risks faced can be
divided into three categories:
(1) Operational risk that are consequential upon various
kinds of banking activities, and which are somewhat
similar for all financial intermediaries, whether shariahcompliant or not. However, the asset-based nature of
financing products in Islamic banking such as murabahah,
salam, istisna’a and ijarah may give rise to forms of
operational risk in contract drafting and execution that
specific to such products.
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(2) Shariah compliance risk – that is (i) risks relating to potential noncompliance with shariah rules and principles in the bank’s operations;
and (ii) he further risk associates with the Islamic bank’s fiduciary
responsibilities as mudarib toward fund providers under the
mudarabah form of contract, according to which in case of
misconduct or negligence by the mudarib the funds invested by the
fund providers become a liability of the
mudarib. Shariah compliance risk is the risk of non-compliance
resulting from a failure of an Islamic bank’s internal systems and
personnel that should ensure its compliance with shariah rules and
principles determined by its shariah board or the relevant body in the
jurisdiction in which the Islamic bank operates.
(3) Legal risks arising either from: (i) the Islamic bank’s operations (legal
risk common to all financial intermediaries); or (ii) problems of legal
uncertainty in interpreting and enforcing shariah contracts.
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• The
following
are
unique
Financing/Investment Modes:
operational
risks
of
Islamic
(i) Murabahah:
It is one of the most predominantly used contracts in Islamic
finance. Apart from credit risk exposures, there are two types of
operational risk relating to the structure of a murabahah contract:
(1)The different viewpoints of murabahah permissibility can be
a source of operational risk. For example, IT systems
employed across jusrisdictions may have to be designed to
meet the requirements of certain jurisdictions.
(2)At the contract signing stage, since the contract requires the
Islamic bank to purchase the asset first before selling to the
customer, the bank needs to ensure that the legal
implications of the contract properly match the commercial
intent of the transactions.
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(3) In addition, problems may arise if the murabahah customer acts as the
Islamic bank’s agent in the purchase of the asset that is subject-matter of
the contract. For the murabahah to be valid, title to the asset must pass
first to the bank and not directly to the customer. The documentation,
including letters of credit, must be drawn up so as to ensure this.
(ii) Salam and Parallel Salam
Salam is a type of forward contract with immediate payment where an
Islamic bank assumes the role of the forward purchaser of a
commodity. In assuming the role of the purchaser, the bank exposes
itself to the following operational risks:
(1) the bank has to accept the goods that are the subject-matter of the
contract even though they are delivered early, should the
specifications be met. The bank may have to incur additional costs
such as warehousing, insurance, or even damage (for perishables) in
the event that it cannot sell the goods promptly following delivery.
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(2) Salam is generally associated with the agricultural sector.
The buyer must either reject goods of an inferior quality to
that specified in the contract, or accept them at the original
price. In the latter case, the goods would have to be sold at a
discount (unless the customer under a parallel salam agreed
to accept the goods promptly following delivery).
(3) For salam with parallel salam, the IIFS may face legal risk if
the goods cannot be delivered at the specified time (unless
the customer under parallel salam agrees to modify the
delivery date).
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(iii) Istisna’a and Parallel Istisna’a:
In this form of contract, risks may include the following:
(1) The Islamic bank may be unable to deliver the asset on time, owing
to time overruns by the sub-contractor under the parallel istisna’a
and may thus face penalties for late completion.
(2) Cost overruns under the parallel istisna’a contract may, unless
agreed with the customer under the istisna’a contract, have to be
absorbed partly or wholly by the Islamic bank.
(3) The subcontractor may fail to meet quality standards or other
requirements of the specification, as agreed with the customer
under the istisna’a contract. The IIFS may face legal risk if no
agreement is reached with subcontractor and the customer either
for remedying the defects or for reducing the contract price.
(4) If the subcontractor turns out to be unable to complete the work,
the bank will need to find a replacement. In certain cases, this may
be very difficult and costly.
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(iv) Ijarah and Ijarah Muntahia Bittamleek (IMB):
In simple terms, an ijarah contract is an operating lease, whereas IMB is
a lease–to-purchase. While operational risk exposures during the
purchase and holding of the assets may be similar to those in the
case of murabahah, other operational risk aspects include the
following:
(1) The Islamic bank needs to ensure that the asset will be used in a
shariah-compliant manner. Otherwise, it is exposed to nonrecognition of the lease income as non-permissable and the need to
reposes the asset and find a new lessee.
(2) If the lessee damages the assets in its possesion, the islamic bank
may face refusal by the lessee to make the damage good. In such a
case, the bank needs to be able to reposes the asset and to take
legal action against the lessee to recover damages.
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(3) If the leased asset is severely damaged or destroyed through
no fault of the lessee, the Islamic bank as a lessor is required
to provide an alternative asset, failing which the lessee can
terminate the lease without paying rentals for the remaining
duration of the contract. Unless the asset is insured, this will
result in a loss to the bank.
(4) The bank may be exposed to legal risk in respect of the
enforcement of its contractual right to reposes the asset in
case of default or misconduct by the lessee. This may be the
case particularly when the asset s a house or apartment that
is the lessee’s home and the lessee enjoys protection as a
tenant.
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(v) Musharakah:
Operational risks that may be associated with musharakah
investments are as follows:
(1) The bank may not perform adequate due diligence in
appraising the venture to be financed and the soundness
and reliability of the customer. Lack of appropriate
technical expertise can be a cause of failure in a new
business activity.
(2) During the musharakah investment period, the bank may
not carry out adequate monitoring of the financial
performance of the venture, and may fail to receive
adequate financial information in order to be able to do
so.
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(vi) Mudarabah:
Since this type of contract may be used on the assets side of the
balance sheet, as well as being used on the funding side for mobilizing
investment accounts, the operational risk is first analyzed from the
asset-side perspective and then from the funding-side perspective
(which is related to fiduciary risk).
(1) Asset-side Mudarabah – Contractually, the bank has no control over
the management of the business financed through this mode, the
entrepreneur having complete freedom to run the enterpeise
according to his best judgment. The bank is contractually entitled
only to share with the entrepreneur the profits generated by the
venture acccording to the contractually agreed profit-sharing ratio.
The entrepreneur as mudarib does not share in any losses which are
borne entirely by the rab al mal. The mudarib has an obligation to act
in a fiduciary capacity as the manager of the bank’s funds, but the
situation gives rise to moral hazard especially if there is information
asymmetry. Hence, in addition to due diligence before advancing the
funds, the bank needs to take precautions against problems of
information asymmetry during the period of investment.
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(2) Funding-side Mudarabah – Since a mudarabah contract is
employed between the Islamic bank and its investment
account holders (IAH), the IAHs share the profit and bar all
losses without having any control or rights of governance
over the Islamic bank.
In return the bank has fiduciary responsibilities in managing
the IAH’s funds typically expects returns on their funds that
are comparable to the returns paid by competitors, but
they also expect the bank to comply with shariah rules and
principles at all times. If the bank is seen to be deficient in
its shariah compliance, it is exposed to the risk of IAHs
withdrawing their funds and, in serious cases, of being
accused of misconduct and negligence. In the latter case,
the funds of the IAHs may be considered to be a liability of
the bank, thus jeopardizing its solvency.
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