Financial risk management for Islamic banking pdf

FINANCIAL RISK MANAGEMENT FOR ISLAMIC BANKING – Book Sample

Contents – FINANCIAL RISK MANAGEMENT FOR ISLAMIC BANKING

• Principles of Islamic Finance 1
• Introduction 1
• Risk Management Issues in Islamic Financial Contracts 28
• Introduction 28
• An overview of financial risks 30
• Identifying risks in Islamic finance 36
• Risk of non-compliance with Shariah rules 41
• Main elements used in financial risk analysis 41
• Mushãrakah contracts of partnership and financial risks 42
• Mudãrabah contracts of partnership 49
• Murãbaha contract agreements and financial risk 54
• Salam contract agreements and financial risk 58
• Istisnã contracts and financial risks 63
• Ijãrah contract agreement and financial risk 68
• 10.1057/9780230598751 – Financial Risk Management for Islamic Banking and Finance, Ioannis Akkizidis and Sunil Kumar Khandelwal
• viii CONTENTS
• Basel II and IFSB for Islamic Financial Risk 80
• Introduction 80
• The Basel accord 82
• Risk management according to Basel II and the Islamic
• financial industry 83
• The three pillars of Basel II 84
• Pillar 2: Supervisory review 96
• Pillar 3: Market discipline 98
• IFSB principles of risk management 99
• Credit Risks in Islamic Finance 109
• Introduction 109
• Credit risk exposure identification 110
• Credit risk assessment models 113
• Credit risk valuation 118
• Credit risk mitigation 133
• Credit rating systems 134
• Validating the credit rating systems 139
• Market Risks in Islamic Finance 148
• Introduction 148
• Identification of market risk factors 149
• Rate of return risk 149
• Commodity risk in Islamic finance 154
• FX rate risks 159
• Equity price risks 160
• Valuation issues on equity prices and FX rates 160
• Quantification of foreign
• exchange risk, equity risk, and commodity risk 161
• Data referring to market risk factors 161
• Sensitivity in market risk 163
• Market risk valuation models 164
• VaR models for Islamic financial contracts 164
• Position and market data 166
• Position risk and exposure risk 168
• Evaluation methods of market risk 168
• Variance–co-variance method 169
• Monte Carlo simulation method 173
• Historical simulation 174
• Back-testing and stress-testing for market risk exposures 176

• 10.1057/9780230598751 – Financial Risk Management for Islamic Banking and Finance, Ioannis Akkizidis and Sunil Kumar Khandelwal
• 6 Operational Risk in Islamic Finance 182
• Introduction 182
• Main elements in operational risk analysis 183
• Identification of operational risk 185
• Measuring operational risks 197
• Loss events 199
• Evaluating operational risk based on VaR analysis 203
• Elements in the framework of the operational
• risk management 206

Operational Risk in Islamic Finance

According to the guidelines of the Islamic Financial Services Board (IFSB),1 financial institutions are exposed to operational risks when losses occur due to failures in their internal controls involving processes, people, and systems.

In addition, institutions should also incorporate possible causes of losses resulting from Shariah non-compliance and the failure in their fiduciary responsibilities. A special characteristic in applying Islamic financial contracts is the strong engagement between the institution and the counterparties. In addition, when applying partnership agreements (i.e. in Mushãrakah and Mudãrabah), both sides may share profits and losses. There is, therefore, an involvement from all parties (banks, buyers, renters, business partners, etc.) in the cause of the operational risk.

This chapter presents all the main elements of operational risk analysis. It shows the three different approaches for operational risk identification analysis, including the self-assessment analysis, the quantitative operational risk indicators, and the operational risk losses. The latter two approaches are extensively discussed as they are mostly used in quantitative operational risk assessment and identification analysis.

The definition of the identification factors and the design of the operational risk mapping are also discussed. The detection of causes, events, and consequences and their interactions are presented, illustrating cases of different types of risks that may appear within this chain. A particular emphasis in operational risks arising from the employees and/or IT systems is also given. Two techniques for measuring operational risks via the key risk indicators and the actual losses are also discussed. Specifically, for the former technique, the identification and data accessing issues are highlighted; whereas, for the latter technique, the internal operational risk loss event data, the external operational risk loss event data, and the losses based on scenario-simulation analysis are covered. Finally, the key issues in the evaluation and management of operational risks are also examined in this chapter.

MAIN ELEMENTS IN OPERATIONAL RISK ANALYSIS

The main drivers in market risk analysis are the commodity price risk, the equity price risk, the FX rate risk, and the mark-up risk market risk factors. Any change in these factors has a computed impact on the value of the bank’s trading portfolio.

On the other hand, the actual losses (their probability and coverage) resulting from the defaults of the counterparties are considered as the main drivers in credit risk evaluation analysis. Operational risk analysis, however, can be based on risk factors that affect the institution’s business performances and objectives; it can also be based on the actual operational risk losses (Figure 6.1). Identification and measurement of the actual risks and their resulting losses is a process that requires a special framework and effort from the institution. There are three different approaches (see Figure 6.2) for operational risk identification analysis:…

Concluding Remarks

Wealth maximisation has been an important goal of the financial institutions for many decades. The quest for generating better revenues is ongoing. Conventional financial institutions have been playing the role of financial intermediation for several years.

However, the finer details of this role have changed dramatically. From simple borrowing and lending institutions, they have emerged as giants who provide a wide range of financial services and have grown to a such a proportion that the stability of entire financial markets depends on the stability of these financial institutions. For efficient financial intermediation, several factors are critical for the organisation.

First, the availability of a basic infrastructure which includes local payment networks, local money markets, a deep and wide financial market, and an adequate legal framework. Second, it requires products, people, systems, and processes. Third, organisation requires an integration of all its activities from a risk perspective. Finally, it needs a sound economy with vigilant supervision. The management of risks in financial institutions can be decisive for the efficient performance of the entire economy.

The Islamic financial institutions re-emerged in the last three decades. They were informally existent in history. The structured Islamic financial industry started with the setting-up of IDB and DIB. The prime reasons for this were: dis-enchantment of the Muslim population with the conventional form of financing, a quest for a religious form of financing, the rapid economic growth of countries with significantly higher Muslim populations, changing political, legal, and economical situations all over the world, and improved wealth among the Muslims. Social dimension has an important position in Islamic finance. Equitable distribution of wealth and income and protection of poor are fundamental to Islamic finance. Thus, prohibition of Riba, avoidance of Gharar, payment of Zakat, and avoidance of Haram activities are the cornerstones of Islamic finance.

Keeping the social objectives in mind, the Islamic financial industry is attempting to evolve and develop. There have been serious efforts towards developing international accounting standards by the AAOIFI and an international risk management framework by the IFSB. The Islamic account-ing is more or less based on conventional accounting.

 However, there are some fundamental differences in terms of representation of assets and liabil-ities, treatment of income and losses, as well as payment of Zakat. Islamic finance has always placed importance on participation in financed business activities. Based on this tenet, Mushãrakah and Mudãrabah were developed, which are two types of partnership contracts in Islamic financing. Islamic scholars have always insisted on using Mushãrakah and Mudãrabah, but this did not happen, due to several reasons. Critics of modern Islamic finance argue that using Murãbaha, which is the most popular type of Islamic con-tract in recent times, is not the long-term solution and should be used spar-ingly. Forward sale is prohibited in Islamic finance, with the exception of Salam and Istisnã. Both these Islamic financial contracts can be used for for-ward trade under specific circumstances.

 Leasing is recognised and is per-mitted through Ijãrah in Islamic finance. The use of all the above-mentioned products is always subject to specific conditions as instructed by Shariah. The Shariah interpretations vary and may create confusion for those who fail to look at the Islamic finance holistically. Extreme caution is thus needed before making any comments on any Shariah ruling.

Financial contracts in Islamic finance are archetypal. They are structured in a specific format and have special relationships between the contracting parties, which sometimes changes during the different stages of the con-tract. Moreover, the risks in Islamic finance are not distributed as conventional finance. The origin, intensity, and the spread of risks are unique for Islamic financial institutions.

 They are mainly concerned with the management of credit, operational, market, and liquidity risk, in addition to several others which are specific to the products, places, and processes. A combi-nation of these two facts produces a treacherous situation for risk management.

On one hand, the relationship is dynamic and on the other hand the risk pro-files are also dynamic. Hence, risk management in Islamic financial institu-tions is far more of a serious issue when compared to conventional financial institutions. Investment contracts, Mushãrakah and Mudãrabah, exposes the institution to all four major risks; that is, credit, operational, market, and liquidity at different stages of the contract. Murãbaha, the most commonly used Islamic financial product, faces mainly credit, operational, and market risk during different time period of the contract. Commodity risk is highly prominent in Salam and Istisnã contracts, although they are also exposed to credit, operational, market, and liquidity risks. Ijãrah is considered to have larger risk exposures, primarily because of the long-term nature. It is exposed to all major risks at different stages of the contract.