Risk Management practices in Islamic Bank of Pakistan

Research Report:

Risk Management Practices In Islamic Bank of Pakistan:

Department of Business Administration BZU_Sub Campus D_G_Khan

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Risk Management practices in Islamic Bank of Pakistan

Risk Management Practices In Islamic Bank of Pakistan:

Submitted To: Sir Nadeem Iqbal Submitted By: Sadia Samad Mahrunisa (MBD-10-15) (MBD-10-21)

Samreen Irshad(MBD-10-12)

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Risk Management practices in Islamic Bank of Pakistan

Risk Management Practices in Islamic Bank of Pakistan

Abstract
The basic aim of this study is to explore or find out that in Pakistan which banks use Risk management practices beside this also know about which types of technique that must be followed to overcome the risk. For this purpose 170 questionnaires on six aspects such as URM, RAA, RI, RM, and CRA must be distributed in two Pakistani cities Multan and D-G-khan. For the estimation of result correlation and regression has been used and the finding conclude that in six aspect of the RMPs the understanding risk, credit risk analysis and risk monitoring are more efficient and there is positive relation. Pakistani bank understand the risk and efficiently monitor the risk. This result can be used for the purpose of improvement of risk management practices in Islamic Bank in Pakistan. Key Words: Risk management practices, Islamic Bank, Pakistan, understanding Risk.

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Risk Management practices in Islamic Bank of Pakistan

Section 1 Introduction
In order to understand the soundness and reliability of banking sector ,there is need of an information regarding risk which is faced by banks now a days and fluctuations in banking industry.Risk is one of important element of business as well as community life.Risk is an ambiguity regarding future outcome or a difference between actual and anticipated result.In this dynamic environment risk is almost changing rapidly due to various shades and aspects of world.People today are not only willing to take risk but they are also keen to get maximum output.Regarding investment decision management of risk is important and one of emerging issue today.Organizations are competing each other on the basis of return.Efficient one risk management practices are helpful for banks to reduce their risk exposure although it is not eliminated completely.Management of risk is one of competitive advantage for banks.Financial risk is defied as result of an action or adverse impact such a imposition of constraints on banking ability to achieve its objective.Risk management is practice that various risk exposure are monitored,identified,measure,mitigated and reported. Islamic banks has been defined as culture and value structure that is governs according to rules of Islam.In addition to conventional banking good governance only when its value is laid down on Islamic Shari'a h.Interest free banking is one of conservative concept,which determine the banking operations which avoid interest. Islamic banks not only avoid interest based transactions except this also keep away from immoral practices to get goals of an Islamic economy (SBP,2010).Islamic banking industry i growing rapidly and also becoming important.The Islamic banking start in Pakistan in 1980's.Over 22 years its a challenging situation for changing structure of financial system according to Islamic system.One of basis issue is Prohibition of "Riba".Riba is defined as situation in which excessive gain or a loan above the principal(zaman & Movassaghi, 2002). Islamic banking is different from other banks on the basis of rejections of Islamic based financial transactions.Risk management is one of challenge for Islamic banks as compared to conventional banks.Because Islamic banks faced with additional risk due to specific features of financing contracts,liquidity
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infrastructure,legal

requirements

and

governance

(Cihak

and

Risk Management practices in Islamic Bank of Pakistan Hesse,2008).Risk management techniques which include risk identification and management being adopted should not confronted with Shari'ah Principle (Khan and Ahmed ,2001). Islamic banks are facing various types of rsik including credit risk,liquidity risk,market risk,foreign exchange risk and interest rate risk.Efficient risk management is essential (AlTamimi &Al- Mazrooei, 2007).Role of Islamic banks in Pakistan are complementing the services as parallel to conventional banks.Islamic banks has established their success to participate with the profound entrenched conventional banking system in Pakistan (Ahmad, Hamayoun, & Hassan, 2010).Islamic banking system is growing rapidly.Islamic banks also recognized the deposit characteristics and investment pattern in order to administer the liquidity (Ismal,2010).The business of Islamic banking has various characteristics, temperament also.The extent of risk confronting and organizations are different due to the concept of profit sharing approach in Islamic banks.Although many studies have been conducted on Islamic banks in whole world (Hallman & Forrest, 1991; Santomero & Oldfield, 1997; Tchankova, 2002; Kallman & Maric, 2004; Fatemi & Flooladi, 2006; Laurentis & mATTERI, 2009; Sensarma & Jayadev, 2009).Academic studies have been done on Islamic banks about risk management.It creates uniqueness on the basis of influence involved.

Objective of study
The main purpose to conduct the research is to find out the degree to which Islamic banks in Pakistan uses effective risk management practices (RMPs).

Significance of study
This study hopes to participate in term of recommending strategies that strengthen the risk management practices of Islamic banks.It creates uniqueness on the basis of influence.It increases overall competitiveness in banking industry.

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Risk Management practices in Islamic Bank of Pakistan

Section 2 Literature Review

Islamic banking is governed by the culture and value structure of Islam along with risk management policies and values levied by Islamic Shariah. Islamic banking avoids interest based transactions, forbidden in the Islamic Shariah and keeps away from unethical practices and involves insistently to achieve the goals of an Islamic economy (SBP, 2010). In Pakistan, the State Bank of Pakistan (SBP) issued detailed criteria for establishment of full-grown Islamic commercial banks in private sector, in December 2001. Al- Meezan Investment bank after receiving first Islamic commercial banking license from SBP in January 2002 started full-fledged commercial banking operations from March 20, 2002 (The Pakistan accountant, 2007). Risks are unsure future events which could influence the success of the banks aims and transactional, strategic and economic objectives. A well-organized risk management structure can direct to Islamic banks toward reducing their risk exposure and increasing their ability to participate in the aggressive marketplace (Iqbal and Mirakhor, 2007). Risk management is the basis of practical banking system. Islamic banks offer several products that doesnt exist in conventional banks and thus bear increasing risks. Now a days Islamic banks are facing different risks including credit risk, liquidity risk, market risk, and interest rate risk etc. So, efficient risk management is required (Al - Tamimi & Al - Mazrooei, 2007). A research conducted on the risk management in Islamic banking in Pakistan by using the same model same model suggested by Al Tamimi and Al Mazrooei (2007) of risk management practices (Khalid & Amjad, 2012). The data was collected through primary sources by distributing questionnaires in Islamic bank of Pakistan of 135 comprehensively with high response rate. The considerable variable was credit risk analysis, risk monitoring and understanding risk management, regression analysis was run and results show that Islamic banking system has significant and positive effect on risk management practices in Pakistan. A proportional analysis on risk management practices between the Islamic and conventional banking system in Bahrain was conducted by (Hussain & Al Ajmi, 2012). The new modified dummy variable bank type was used to make an optimal assessment. The focus of the study was on understanding risk and risk management, risk assessment and credit risk analysis have significant effect on risk management practices in Islamic and conventional banks of Bahrain. The comparative analysi indicate that the understanding of risk and risk management only causes the significant difference between Islamic and conventional banking in Bahrain. While other variables were not significantly different. A comparative study on liquidity risk practices between Islamic and conventional banks of Pakistan was conducted by (Akhtar, M.F., Ali, k. and Sadaqat, S., 2011). The aim of the study was to examine and evaluate the liquidity risk related with the solvency of a financial institution and liquidity risk management (LRM) through comparative analysis between conventional and
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Risk Management practices in Islamic Bank of Pakistan Islamic banks of Pakistan. Islamic banks required additional efforts for scaling liquidity management due to their distinctiveness and compliance with principles of Shariah. This paper is about the impact of the Size of the firm, NWC, ROE, Capital adequacy and Return on assets (ROA) with liquidity risk management in conventional and Islamic banks of Pakistan. The study based on secondary data of four years i.e. from 2006-2009. The findings show the positive but insignificant relationship of size of the bank and networking capital to net assets with liquidity risk in both models. In addition, findings suggest that Capital adequacy ratio in conventional banks and Return on assets in Islamic banks are positive and significant at 10% significance level. The next study to investigate the current risk management practices implement by the commercial banks in Pakistan was conducted by (Shafiq & Nasir, 2011). The data was collected through primary and secondary sources. The inference of the study was significant difference between public and private sector and financial soundness difference in value for each type of commercial bank. Further, it indicates that there is the gap of training courses among employees to undertake risk management. The research was conducted to demonstrate the level of risk management implement by the Islamic banking in the Brunei Darussalam (Hassan, 2009). The difference of variety of products causes risk exposure variation between conventional and Islamic banks. Islamic banks are proficiently practicing the risk management techniques. Risk identification, risk assessment and analysis were the most impel variables in todays Islamic system in Brunei. Through regression model findings show that these variables need to be considered and to undertake the distressing situation in the Islamic banking sector. Another study was conducted for understanding the credit risk management system of commercial banks for the economy of less developed countries, in Tanzania by (Richard et al., 2008). The main finding was that the element of credit risk management differs in commercial banks operating in developed and less developed economy. For successful credit risk management system, environment is important consideration, in which bank is operating. Credit risk is considered to be most important risk in Islamic banks (Arittin et al., 2007). In the earlier of the twenty first century, the Islamic bank regarding risk management was investigated by (Khan & Ahmed, 2001). The sample size was 17 Islamic banks across ten different countries. The data was collected through primary source of distributing questionnaires at different field levels. The major finding was the murabha contract which is uncertain and cannot hedge by using tools. The Risk management theory explain the risk management term as: the method through which decisions are made(Frocdick, 1997). Our basic objective is to measure the RMPs in Islamic banks of Pakistan.

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Risk Management practices in Islamic Bank of Pakistan

Research Framework:
A research framework on RMPs and risk management processes have been given by Rosman in 2009.The purpose of this frame is to explore the relation among the risk management practices and its foe expect which is as (1) URM, (2) RAA, (3) RI, (4) RM, (5) CRA

Research Model:

URM
+ (H1)

RAA RI

+ (H2) + (H3)

RMP
+ (H4)

RM
+(H5)

CRA
I.V D.V

URM: understanding risk and risk management, RAA: risk assessment and analysis; RI: risk identification; RM: risk monitoring; CRA: credit risk analysis RMP: Risk management practices.

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Risk Management practices in Islamic Bank of Pakistan

Section 3 RESEARCH METHODOLOGY:

Brief overview of the objective: Under this study the main objective is which Islamic bank in Pakistan use effective RMPs.Another purpose is to find out the suggestions that are necessary for the improvement of weaker financial banking sector in Pakistan. Data collection: Collection of data for the purpose of this research is collected from the banking sector of Pakistan. Questionair is used to collect the data. There are many resonos to used the questionair one of that is less expensive and less time is consume. The questionair used under this study is adopted that is used by the Al-Tamimi and Al-Mazrooei in 2007. The questionair developed covers six aspects including, understanding risk and risk management (URM), Risk assesment and analysis (RAA), isk identification (RI), Risk monitoring (RM), Cradit risk analysis (CRA), and Risk management practices (RMP). The purpose to evaluate the research objective the following hypothesis are formulated: H1: There is positive relationship between understanding risk and risk management and risk management practices. H2: There is positive relationship between risk assessment and analysis and risk management practices. H3: There is positive relationship between risk identification and risk management practices. H4: There is positive relationship between risk monitoring and risk management practices. H5: There is positive relationship between credit risk analysis and risk management practices. Data has been collect from the two Pakistani cities D-G-Khan and Multan from the four banks and the sub branches of all these four banks. The study is based on the Random sampling technique. Total 170 questionair were distributed among these banks out of which 150 returned back and 20 were not returned because of the lack intrest of the employees. Total 45 question must be in questionair 42 questions are related to the variables and 3 questions related to the respondents demodraohic characteristics. Measures Understanding risk and risk management (URM) was measured by using likert scale ranking such as 1 (strongly agree) 5 (strongly disagree), total item consist of 8. Risk assessment and
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Risk Management practices in Islamic Bank of Pakistan analysis (RAA) is measured through likert scale, total item consist of 7 including such as Your Islamic bank is responsiorble for to analysis risk . Risk identification (RI) was also measured by likert scale, total item consists of 5.Risk monitoring (RM) consists of 6 including as monitoring the effectiveness odd risk management is an integral part of daily management reporting. Credit risk analysis (CRA) was measured by likert scale total item of CRA is 7 including such as Islamic bank undertakes the credit worthiness before granting the loss. Risk management practices (RMP) was also measured by liker scale, total item of RMP was 9 one of the Example is Islamic banks executive management regularly reviews the organizations performance in managing its business risk. Data Anylisis Spss version 20 for the purpose of analyzes the data. Using Chronbachs alpha reliability of the scale is evaluated. In order to measure the direction and similarly the strengthen of relationship among the dependent and independent variables Spearmans correlation was applied. In order to estimate the relationship between RMP and the other explanatory variable such as URM, RAA, RI, RM, CRA the regression analysis was applied As follows which is given as: RMP= f (URM, RAA, RI, RM, CRA) RMP = Risk management Practices URM = Understanding risk and risk management RAA = Risk assessment and analysis RI = Risk identification

RM = Risk monitoring CRA = Credit risk analysis

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Risk Management practices in Islamic Bank of Pakistan

Section 4 RESULT AND DISCUSSION:

Reliability analysis: For te purpose of reliability analysis Chronbachs Alpha is used.As it is already mentioned in the methodology that there ara total 45 questions 3 related to demographic and remaining 42 related to vriables.Total six variables has been used in the study for finding such as understanding risk and risk management, Risk assessment and analysis, Risk identification, Risk monetiring, Credit risk analysis as independent variable Risk management practices as dependent variable. Table 4.1 shows the reliability analysis.

variable
URM RAA RI RM CRA RMPs

Cronbachs Alpha
.632 .658 .528 .726 .62 .788

Descriptive Analysis: Table 4.2 shows the mean and standard deviation of all these six variables.Eight question has been asked from the respondents that are related to the understanding risk and risk management.From the answers of the respondents it is clear that the Pakistani bank much beter understand the risk. Eight Research Questions has been asked from the respondent under the aspect of Risk.The mean of the URM is (M = 3.75) which shows that bank much beter understand the risk.The second independent variable such as the risk assessment and analysis its mean and standard deviation are shown in the table that predit the result that the bank refer toward the risk assessment and analysis and most of the bank for the purpose of the accesing the potential risk follow the quantitative techniquet.The mean of RAA is (M = 3.22). One of the most important predictor is the risk identification that are measured by using likert scale.From the respondent poin of view it is clearly shows that the bank must identify the risk.The mean of the RI is ( M= 312)

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Risk Management practices in Islamic Bank of Pakistan Table also shows the mean and standard deviation of the risk monitoring.from that predict the result that if the bank efficiently monitor the risk then that would become the result of the maximum and high performance.The mean of the RM is ( M= 3.67).One of the predictorery is credit risk analysis the mean and standard deviation of CRA is must shown in the table 4.2 that shows bank are very sharp when granted the loans.The mean of the CRA is ( M = 3.75). Dependent variable of the study was risk management practices RMPs it clears that the Pakistani banks are so much in favour of RMPs.The mean and standard deviation predict that result.The mean of the RMPs is ( M = 3.97). Table 4.2 descriptive Analysis:

variable
URM RAA RI RM CRA RMPs .

Mean
3.75 3.22 3.12 3.67 3.75 3.97

S.D
.49 .45 .40 .48 .49 .50

CORRELATION:
Table 4.3 shows the result of the correlation.According to that there is positive relationship between the URM and RMPs (r = .579 p<.01).beside this there is positive association between RAA and RMPs (r =.411, P< .01 ).A significant rest positive relationship between RI and the RMPs ( r = .375, p< .01 ). The relationship between the RM and CRA is also positive that is shown as ( r = .597, p .01) and ( r = .331, p< .01).

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Risk Management practices in Islamic Bank of Pakistan The result of Correlation test:

Variables URM RAA RI RM CRA RMPs

URM 1 .419** .322** .498** .214** .579**

RAA

RI

RM

CRA

RMPs

1 .497** ..511** .351** .411** 1 .432** .344** .375** 1 .329** .597** 1 .331** 1

Correlation** is significant at the o.o1 level and correlation* is significant at the level 0.05 level .

Regeration Analysis:
Table 4.4 shows the result that we get from the regeration resuls.from the data analysis it shows that the Beta coefficient of the variable RM is large which is (0.352) that shows that the RM has more contribution and the relation among the RM and the RMP is highly significant . The relation among the RM and the risk management practices is highly positive.Similarly the relation between the understanding risk ang risk management and credit risk analysis is also highly positive association the beta of these two variable is (0.176), (0.184).The beta value of risk identification and the risk assessment and analysis is (0.019), (0.020).

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Risk Management practices in Islamic Bank of Pakistan Table 4.4 Regerration result.

I.V Constant
URM RAA RI RM CRA

Beta

T 0.322

Sig 0.701
0.039 0.721 0.710 0.000 .019

0.176 0.020 0.019 0,352 .184

2.011 0.201 0.200 3.321 2.247

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Risk Management practices in Islamic Bank of Pakistan

Section 4 Discussion of the Result:

From the above data analysis it can be concluded that there is positive association between the URM, RRA RM, RI, RM, CRA and RMPs.from the study we know that the URM, RM, CRA are highly significant. Understanding Of risk and risk Management URM The above analysis predict that The mean of the URM is 3.12 and the beta value is 0.176 that shows that the the Islamic bank efficiently manage risk not only manage the risk also better understand the risk efficiently and effectively.So the relationthat we conclude from the result that is that there is positive relation between these two variables that support our hypothesis that is: H1: There is positive relationship between understanding risk and risk management and risk management practices. Risk Monitoring RM From the above analysis it is conclude that there is positive relation among the RM and the RMPs. The beta value of the Rm is .352 that show that the relation between these two variable is highly significant .It indicate that the Islamic bank monitor risk very carefully and fully control there systems thats way the relation between the RM and RMPs is highly positive which support our hypothesis: H4: There is positive relationship between risk monitoring and risk management practices. Credit Risk Analysis: One of the Important type of risk is CRA.The mean of the CRA is 3.75 and the beta value is .184.that predict that the Islamic bank should undertake specific analysis and there must be highly significant and positive relationship between the CRA and the RMPs which suppotted our hypothesis such as: H5: There is positive relationship between credit risk analysis and risk management practices. Risk Identification RI
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Risk Management practices in Islamic Bank of Pakistan Similarly To identify the risk there is condition firstly understand that risk if the member in the branches clearly understand the risk then they also identify it.so from the mean and beta value it is concluded that Islamic bank in Pakistan firstly know and understand the risk then identify it that are related to there objectives.so that support our hypothesis which is as: H3: There is positive relationship between risk identification and risk management practices. Risk Assesment and Analysis As the hypothesis is that the association between the RRA and the RMPs is positive so from the result it is concluded that participant in Islamic banking successfully analyse and assess the risk which support our hypothesis that is: H2: There is positive relationship between risk assessment and analysis and risk management practices. From all of this it is predicted that the value of beta of the URm, CRA, RM is highly significant Bt the beta value of RI and RAA is insignificant but still support our hyposis that the relation among the URM, RAA, RI, RM, and CRA with rrespect to RMPs is positive. Table 4.5 shows the result of all hypothesis: No Hypothesis H1 There is positive relationship between understanding risk and risk management and risk management practices (RMPs). H2 There is positive relationship between the risk assessment and analysis and the risk management practices(RMPs). H3 There is positive relationship between the risk identification and risk management practices (RMPs). H4 There is positive relationship between the risk monitoring and risk management prtices. H5 There is positive relationship between credit risk analysis and risk management practices (RMPs). Results Accepted Accepted Accepted Accepted Accepted

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Risk Management practices in Islamic Bank of Pakistan

Section 5 Conclusion:
From the major results and findings, it can be concluded that Risk Management Practices (RMPs) are generally understood throughout the Islamic banking system in Pakistan. All the aspects of risk management are positively associated with RMPs. The bivariate correlation is calculated between independent variable and dependent variable, the findings indicate that independent variables such as, understanding risk and risk management (URM), risk identification (RI), risk assessment and analysis (RAA), risk monitoring (RM), credit risk analysis (CRA) and dependent variable as risk management practices (RMPs) are positively correlated. The RM and URM are the most imperative and significant variables in RMPs. In order to assess the effect of independent variable on dependent variable linear regression model is used. The beta values of three independent variables were positive and statistically highly significant in the case of RM, URM and CRA. The beta values of RI and RAA had insignificant positive impact on risk management practices (RMPs). The findings also indicate that the specific determinants of risk management practices (RMPs) significantly affect the risk management in Islamic banking industry of Pakistan. The basic objective of study is also fulfilled by providing guidance to Islamic banking industry for managing risks effectively and efficiently through risk management practices (RMPs) while making decision.

Limitation and Recommendation:

One of the limitation of this study is due to shortage of time the findings are limited to risk management practices of Islamic bank of Pakistan. On the basis of conclusion and personal assessment it is recommended that the Islamic banks cannot ignore the risk fully and it is required to properly manage it. Islamic banks should consider importantly risk management practices and its all aspects. Islamic banks should also focus their attention towards especially in RI and RAA aspects of RMPs. On the basis of importance of Islamic banking industry in Pakistan, the separate risk management department should build up and employment of risk management officers to manage this departments operations should require. Islamic banks can encourage having their own Islamic banking training forum to improve the staff quality.

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Risk Management practices in Islamic Bank of Pakistan

Section 6

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Risk Management practices in Islamic Bank of Pakistan Ahmed, T. k., (2001). Risk management monothesism money treade (an analysis of problem in monothesism money). Jeddah - Saudi Arabia. Carey, A., (2001). Effective risk management in financial institutions: the Turnbull approach record. Balance Sheet, 9(3), 24-27. Jhorge, F., & Ebogue, G. A. (1977). "Role of Islamic Banks in Economic Development". money Analysts Journal, 80-96.

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