Understanding Risk Management in Islamic Finance:
Risk Management in Islamic Banking can be defined as a forecasting of financial risks and applying necessary procedures to minimize their impact, while practicing the Islamic Banking and Takaful. Risk management guidelines provide set of best practices, for establishing and implementing effective risk management in Islamic finance. There are fifteen principles of risk management, underlying the business objectives that Islamic banking and takaful institutions may adopt.
These fifteen principals for risk management in Islamic finance are divided into following six categories:
- Credit Risk.
- Equity Investment Risk.
- Market Risk.
- Liquidity Risk.
- Rate of Return Risk.
- Operational Risk.
Categories and Principles of Risk Management in Islamic Banking and Takaful:
1. CREDIT RISK:
Credit risk includes the risk arising in the settlement and clearing transactions. It is defined as: “Potential that counterparty fails to meet its obligations, in accordance with agreed terms”.
Credit risk is applicable to:
- Institutions have financing exposures to receivables and leases. For Example: Murabahah, Diminishing Musharakah, and Ijarah; and;
- Institutions who are managing the working capital financing transactions, and projects. For Example: Salam, Istisna, or Mudharbah.
Here are the principles for minimizing the “Credit Risk”:
For effective risk management in Islamic banking, institutions shall have comprehensive risk management and reporting process. The process shall take into account, appropriate steps to comply with Shariah rules and principles, and ensure reporting it to supervisory authority.
Institutions shall have a strategy for financing, using various Shariah compliant instruments, in order to recognize potential credit exposures, which may arise at different stages of various financing agreements.
Institutions shall carry out a due diligence review, prior to deciding an appropriate Islamic financing instrument.
Institutions shall have appropriate methodology, to measure and report possible credit risk under each Islamic financing instrument for an ideal risk management in Islamic banking.
Institutions shall have Shariah compliant credit risk mitigating techniques for each Islamic banking and takaful instrument. These techniques must include the following:
- Methodology for setting mark-up rates according to the risk rating, where expected risks should be taken for pricing decisions;
- Permissible and enforceable collateral and guarantees;
- Clear documentation as to, whether or not, purchase orders are cancelable; and;
- Clear procedures for governing laws for financing transactions.
2. EQUITY INVESTMENT RISK:
It is the risk arising from entering into a partnership, for the purpose of participating in a particular financing, in which investor shares in the business risk. Here are the principles to minimize Equity Investment Risk:
Islamic financial institutions shall have appropriate risk management, and reporting processes, for risk characteristics of equity investments.
For a secure risk management in Islamic finance, Islamic banking and takaful Institutions shall ensure that their valuation methodologies are appropriate and consistent, and shall assess potential impacts of their methods on profit calculations and allocations.
For an ideal Shariah compliant risk management in Islamic banking or takaful, institutions shall establish the exit strategies, in respect of their equity investment activities, subject to the approval of the institution’s Shariah Advisor.
3. MARKET RISK:
It is defined as “Risk of losses in on and off-balance sheet positions, arising from movements in market prices”. It is related to the current and future volatility of market values of specific assets. For Example:
- Commodity price of a Salam asset;
- Market value of Sukuk;
- Market value of Mudharbah assets purchased; and;
- Foreign exchange rates.
Here is the principle to minimize the “Market Risk”:
Institutions shall have an appropriate framework for market risk management, including reporting of all assets held.
4. LIQUIDITY RISK:
It is the potential loss to Islamic financial Institutions, arising from their inability, either to meet their obligations or to fund increases in assets. Here are the principles for minimizing the “Liquidity Risk”:
Institutions shall have a liquidity management framework, including reporting taking into account separately, and liquidity on an overall basis.
Institutions shall assume liquidity risk, commensurate with their ability to have sufficient recourse to Shariah compliant funds.
5. RATE OF RETURN RISK:
Institutions are exposed to this risk on their overall balance sheet exposures. Rate of return risk differs from interest rate risk, as institutions are concerned with the result of their investment activities, at the end of investment-holding period. Such results cannot be pre-determined exactly.
Here are the principles to minimize “Rate of Return Risk”:
Institutions shall establish reporting process to assess market factors, which affect rates of return on assets, in comparison with the expected rates of return for PLS deposit holders.
Institutions shall have an appropriate framework for managing displaced commercial risk, where applicable.
6. OPERATIONAL RISK:
They arise due to processes, people, and systems; and reputational risk arise due to failures in governance, business strategy, and process. To counter them, institutions should assure soundness of operations and reliability of reporting. The last two principles are about minimizing the “Operational Risk”:
Institutions shall ensure adequate systems and controls, including compliance with Sha-re-ah rules and principles.
Institutions shall have appropriate mechanisms to safeguard the interests of all fund providers. Specially for PLS deposit holder’s funds, institutions shall ensure that bases for asset, revenue, expense, and profit allocations are applied and reported properly.
Reporting Process for Risk Management in Islamic Finance:
There is a comprehensive reporting process and Risk Management in Islamic Banking, including appropriate board and senior management oversight, to identify, measure, monitor, report and control relevant categories of risks. The process shall take into account appropriate steps to comply with Shariah rules and principles and to ensure the adequacy of relevant reporting of risk management in Islamic banking to the supervisory authority.
- As with any financial institution, the risk management activities of IBIs require active oversight by the BOD and senior management. The BOD shall approve the objectives of risk management in Islamic banking and strategies, policies and procedures that are consistent with the IBIs’ financial condition, risk profile and risk tolerance. Such approvals shall be communicated to all levels in the IBI involved in the implementation and guidelines of risk management in Islamic banking.
- The BOD shall ensure the existence of an effective risk management structure for conducting IBI’s activities, including adequate systems for measuring, monitoring, reporting and controlling risk exposures.
- IBIs shall have in place a Shariah Advisor, in accordance with sound principles of corporate governance and CENTRAL BANK’s Fit and Proper Criteria for Shariah Advisors, to oversee that IBIs’ products and activities comply with Shariah rules and principles as advised by CENTRAL BANK and Shariah Advisor.
- The BOD shall approve limits on aggregate financing and investment exposures to avoid concentration of risk and ensure that IBIs hold adequate capital against these exposures. The BOD shall review the effectiveness of the periodic activities of risk management in Islamic finance and make appropriate changes as and when necessary.
- Senior management shall execute the strategic direction set by the BOD on an ongoing basis and set clear lines of authority and responsibility for managing, monitoring and reporting risks. The senior management shall ensure that the financing and investment activities are within the approved limits.
- Senior management shall ensure that the functions for the risk management in Islamic banking should be separated from risk taking function and is reporting directly to the BOD or senior management. Depending on the scope, size and complexity of IBI’s business activities, the risk management function is carried out by personnel from an independent unit of risk management in Islamic banking. These personnel shall define the policies, establishes procedures, monitor compliance with the established limits and report to top management on risk matters accordingly.
Execution of Risk Management in Financial Institutions:
- IBIs shall have a sound process for executing all elements of risk management, including risk identification, measurement, mitigation, monitoring, reporting and control. This process requires the implementation of appropriate policies, limits, procedures and effective management.
- Information systems (MIS) for internal risk reporting and decision making that are commensurate with the scope, complexity and nature of IBIs’ activities.
- IBIs shall ensure that an adequate system of controls with appropriate checks and balances is in place. The controls shall (a) comply with the Shariah rules and principles; (b) comply with applicable regulatory and internal policies and procedures; and (c) take into account the integrity of processes of the risk management in Islamic banking.
- IBIs shall make appropriate and timely disclosure of information to depositors having deposits on Profit and Loss Sharing basis, minimum requirements of which are specified by CENTRAL BANK in its Guidelines for Shariah Compliance in IBIs”, so that they are able to assess the potential risks and rewards of their deposits and to protect their own interests in their decision making process.
Application of Emergency and Contingency Plan:
The senior management shall draw up an emergency and contingency plan, approved by the board of directors in order to be able to deal with risks and problems which may arise from unforeseen events.
Integration of Risk Management:
While assessing and managing risk, the management should have an overall view of risks the institutions is exposed to. This requires having a structure in place to look at interrelationships of risk management in Islamic banking, across the organization. Such a setup could be in the form of a separate department or bank’s Risk Management Committee could perform such function. The structure should be such that ensures effective monitoring and control over risks being taken.
For each category of risk, IBIs are encouraged to establish systems/models that quantify profile of better risk management in Islamic banking. The results of these models should be assessed by independent risk review function.
The IBIs should develop a mechanism which should, to the possible extent, monitor that funds provided by them were utilized for the purpose these were advanced.
Role of Finance Administration Department:
It should be separated from finance origination department. It should be among the responsibilities of Finance Administration Department to monitor that the documents are obtained according to the requirement as specified in the product. For example, the dates play a very important role in Murabahah transactions and any transaction can be rendered invalid if the sequencing of obtaining documents is changed.
Management Information System:
The IBIs should specify control reports to be prepared by independent department that should be periodically submitted to board or senior management committee.
IBI shall ensure that staff has been adequately trained regarding Shariah principles and procedures. There should be ongoing emphasis on staff training and development planning with clear objective for individual staff members. For this purpose, periodic workshops should be arranged by the IBI in coordination with Shariah Advisor.
Risk management is an important part of Islamic banking, and this lecture is taken from our Islamic finance certification. In the next lecture, you will understand the fundamentals of Islamic financial instruments. These lectures are also covered during the Islamic finance degree program, which is offered at AIMS.