Understanding Risk Management in Islamic Banking and 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. Risk Management Guidelines provide a set of best practices for establishing and implementing effective risk management in Islamic Banking. These Guidelines set out fifteen principles of risk management that give practical effect to managing the risks underlying the business objectives that Islamic banking institutions may adopt.
Guidelines for Risk Management in Islamic Banking:
The principles contained in these Guidelines are designed to complement the current risk management principles issued by the ‘Basel Committee on Banking Supervision’ (BCBS) and other international standard-setting bodies. These guidelines for Risk Management in Islamic Banking provide specific guidance for each category of risk, drawn from discussion on industry practices, outlining a set of principles applicable to the following six categories of risks:
- Credit Risk.
- Equity Investment Risk.
- Market Risk.
- Liquidity Risk.
- Rate of Return Risk.
- Operational Risk.
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.
Board of Directors and Senior Management Oversight:
- 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 banking 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 risk management function 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.
Process for Risk Management in Islamic Banking:
- 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 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 Murabaha 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 course. This course is also covered during the diploma in Islamic finance and master in Islamic finance programs offered at AIMS.