Various Risks in a Bank

Equity Risk Trading Risk Gap Risk Interest Rate Risk Currency Risk Commodity Risk

Market Risk

Risks Exposure in Islamic Financial Institutions

By Ahmed Ali Siddiqui EVP, Product Development & Shariah Compliance (PDSC) Meezan Bank Limited Nov 4, 2010

Transaction Risk

Counterparty Risk Issuer Risk

Banks Risks

Credit Risk

Portfolio concentration risk

Liquidity Risk Operational Risk Regulatory Risk Human Factor Risk

Process Risk Infrastructural Risk Model Risk

What is a Risk?

Risk in Conventional Banking A conventional bank is generally expose to following types of risks: Credit Risk Market Risk Liquidity Risk Operational Risk Regulatory Risk Reputational Risk Interest Rate Risk

The term risk is generally viewed as negative and is often used synonymously with "probability". The Oxford dictionary defines the word risk as: The possibility of something bad happening at sometime in the future; a situation that could be dangerous or have a bad result.

Risk in IFI An Islamic bank faces variety of risks in addition to conventional banking risks: Reputation Risk Shariah non-compliance risk Credit Risk Market Risk Product/Mode of Financing Risk Liquidity Risk Operational Risk Legal Risk Benchmark Risk Fiduciary Risk

Reputational Risk in Islamic Banks

Risk Management Risk Management is a continuous, measured, rational and vigilant process. It is designed to identify and manage the risks inherent in the banks business. The goal of an effective Risk Management is not only to avoid financial losses, but also to ensure that the bank achieves its targeted financial results with a high degree of reliability.

Reputational Risk in IFI

Business reputation is established by gaining and retaining the confidence and trust of the stakeholders in the business: customers, suppliers and employees, as well as shareholders. IT IS THE SINGLE MOST IMPORTANT ASSET For IBIs, Reputation risk is about getting everything else right & in accordance with Shariah guidelines. Reputational risk management is supported by the right mindset, plans, processes and practices, which engender and sustain the trust of all and each category of corporate stakeholder.

Shariah Non-Compliance Risk in Islamic Banks

Credit Risk in Islamic Financial Institutions

Shariah Non-Compliance Risk

Shariah non -compliance risk is the risk that arises from
IBIs failure to comply with the Shariah rules and principles prescribed by State Bank of Pakistan and Shariah Advisor of the IBIs . Shariah compliance is critical to IBIs operations and such compliance requirements must permeate throughout the organization and their products and activities. Proper controls & system including Internal Shariah Audit & Compliance must be developed

Credit Risk in Islamic Bank

Credit risk is generally defined as the potential that a counterparty fails to meet its obligations in accordance with agreed terms. This definition is applicable to IBIs managing the financing exposures of: receivables and leases (for example, Murabahah, Diminishing
Musharakah and Ijarah) and working capital financing transactions/projects (for example, Salam, Istisna or Mudarabah).

IBIs need to manage credit risks inherent in their financings and investment portfolios relating to default, downgrading and concentration. Credit risk includes the risk arising in the settlement and clearing transactions.

Principles of Credit RM
1. IBIs shall have in place a strategy for financing, using various instruments in compliance with Shariah, whereby they recognize the potential credit exposures that may arise at different stages of the various financing agreements. 2. IBIs shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrument.

Operational Risks in IBI

The risk of losses resulting from inadequate or failed internal processes, people, and systems or from external event It is said to include the risk of loss from IT and computer failures, poor documentation or fraud, thus covering "legal" risk but not necessarily "strategic" risk.

3. IBIs shall have in place appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrument. 4. IBIs shall have in place Shariah-compliant credit risk mitigating techniques appropriate for each Islamic financing instrument.

Operational Risks in IBI

1. IBIs shall have in place adequate systems and controls, including Shariah Advisor, to ensure compliance with Shariah rules and principles. 2.

Operational Risks in Islamic Banks

IBIs shall have in place appropriate mechanisms safeguard the interests of all fund providers.

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3. Proper & continuous training of staff on products & Shariah guidelines 4. Where PLS deposit holders funds are commingled with the IBIs own funds, the IBIs shall ensure that the bases for asset, revenue, expense and profit allocations are established, applied and reported in a manner consistent with the IBIs fiduciary responsibilities. 5. A Proper Pool Management System is must.

Market Risks in Islamic Banks

Liquidity Risks in Islamic Banks

Market Risks in IBI

Market risk is defined as the risk of losses in on - and off-balance sheet positions arising from movements in market prices i.e. fluctuations in values in tradable, marketable or leaseable assets (including sukuk) and in off-balance sheet individual portfolios (for example restricted investment accounts).
The risks relate to the current and future volatility of market values of specific assets For example, the commodity price of a Salam asset, the market value of a sukuk, the market value of Murabaha assets purchased to be delivered over a specific period) and of foreign exchange rates.

Liquidity Risk in IBI

Liquidity risk arises from either difficulties in obtaining cash at reasonable cost from borrowings or sale of assets. The liquidity risk arising from both sources is critical for Islamic banks. As interest based loans are prohibited by Shariah, Islamic banks cannot borrow funds to meet liquidity requirement in case of need. Furthermore, Shariah does not allow the sale of debt, other than its face value. Thus, to raise funds by selling debt-based assets is not an option for Islamic financial institutions.

Legal Risks in Islamic Banks

Benchmark Risk in Islamic Banks

Legal Risk in IBI

Given the different nature of financial contracts, Islamic banks face risks related to their documentation and enforcement. As there are no standard form of contracts for various financial instruments, Islamic banks prepare these according to their understanding of the Shariah, the local laws, and their needs and concerns. Lack of standardized contracts along with the there are no litigation systems to resolve associated with enforceability of contracts counterparty increases the legal risk associated Islamic contractual agreements. fact that problems by the with the

Benchmark Risk in IBI

Financial institutions use a benchmark rate, to price different financial instruments. Therefore changes in the market interest rate, introduce some risks in the earnings of Islamic financial institutions The nature of some fixed income assets is such that the profit is fixed for the duration of the contract. As such if the benchmark rate changes, the mark -up rates on these fixed income contracts cannot be adjusted. As a result Islamic banks face risks arising from movements in market interest rate. Therefore,benchmark risks are similar to interest rate risks.

Fiduciary Risk in Islamic Banks

RISKS INHERENT IN ISLAMIC FINANCIAL PRODUCTS

Fiduciary Risk in IBI

A lower rate of return than the market rate introduces fiduciary risk, when depositors/investors interpret a low rate of return as breaching of investment contract or mismanagement of funds by the bank (AAOIFI 1999).

Islamic Financial Products

Islamic financial instruments are asset based (Murabaha, Salam and Istisna which are based on the sale or purchase of an asset, and Ijarah which is based on the selling the benefits of such an asset), profit-sharing (Musharakah and Mudarabah) which may be based on the assets. Murabaha Ijarah Musharakah Diminishing Musharakah Salam Istisna / Tijarah

Fiduciary risk can be caused by breach of contract by the Islamic bank. For example, the bank may not be able to fully comply with the Shariah requirements of various contracts.

Murabaha
RISK CATEGORY Credit Risk

Mitigants
MITIGANTS Direct payment to the supplier/vendor and proper pre-inspection. Takaful of goods during transit and induce customers to submit declaration immediately after the purchase of goods. Obtain sufficient collateral and adopt staggered payments Secure the collateral upon executing the promise to purchase with the customer

Murabaha contract refers to an agreement whereby the bank sells to a customer at cost plus an agreed profit margin. A specified kind of asset is purchased and acquired by the bank based on a promise to purchase by the customer, which can be a binding or non -binding promise to purchase.

Agency Risk

Ownership transfer/Asset Risk

Credit Risk

Repayment/ Default Risk Price Risk

Credit Risk

Market Risk

Risks Inherent in Murabaha

RISK CATEGORY

Mitigants
MITIGANTS Make separate pools for different maturities considering their different maturity dates

Agency Risk (Mis-utilization of funds) Ownership transfer/Asset Risk Repayment/Default Risk Price Risk Liquidity Risk Profitability Risk Legal Risk

Liquidity Risk Liquidity Risk

Profitability Risk Legal Risk

Operational A charity may be imposed to Risk(loss in discourage a delay in payment of profits) Murabaha price. Operational Risk(Error in Documentatio n) To secure the position, the bank shall ensure that the promise to purchase is properly documented and it is legally enforceable. Same as above Ensure that the relevant staff has appropriate training and has proper knowledge of Shariah principles as well.

Shariah Compliance Risk

Legal Risk Shariah Compliance Risk

Legal Risk Operational Risk

Ijarah
RISK CATEGORY Credit Risk

Mitigants
MITIGANTS Risk mitigated by the market value of Ijarah asset which may be repossessed and collateralized . Ensure that the promise to Ijarah is properly documented and is legally enforceable Mitigated by the market value of the Ijarah asset, which is repossessed. Mitigated by taking a profit on Sale in case of early termination.

In an Ijarah contract - the bank as the lessor maintains its ownership in the leased asset whilst merely transferring the right to use the asset, or usufruct, to an individual/enterprise as the lessee, for an agreed period of time at an agreed consideration.

Repayment/ Default Risk

Price Risk

Market Risk

Residual value Risk Early Termination Risk

Market Risk

Market Risk

Risks Inherent in Ijarah

RISK CATEGORY Liquidity Risk

Mitigants
MITIGANTS Proper contingency funding plans,which include highly liquid assets and the sources of funds that the bank can use in the crises. Ensure that the relevant staff has appropriate training and has proper knowledge of Shariah principles as well.

Repayment/Default Risk Price Risk Residual value Risk Early Termination Risk Liquidity Risk Shariah Compliance Risk Operational Risk

Liquidity Risk

Shariah Operational Risk Compliance

Ijarah Asset Impaired)

Operational Risk

This can be covered through takaful of Ijarah asset

Diminishing Musharakah (DM) Diminishing Musharakah involves taking share in the ownership of a specific asset and then gradually transferring complete ownership. Three components involved:
Joint ownership of the Bank and customer Customer uses the share of the bank and
RISK Ownership/A sset Risk Partner Risk Capital Impairment Risk Cancellation Risk Purchase Price Risk Legal Risk CATEGORY Credit Risk Credit Risk Credit Risk

Mitigants
MITIGANTS This can be covered through takaful of assets. This risk is mitigated by the assets value as collateral This can be covered through takaful of goods during transit

Market Risk

In order to reduce this risk, the bank must obtain sufficient collaterals. This can be covered by having a good market study and project feasibility This can be migrated by executing proper legal documentation.

pays the rent for it.

Redemption of the share of the Bank by the

Market Risk

customer

Legal Risk

Risks Inherent in DM

Musharakah

Ownership/Asset Risk Partner Risk Capital Impairment Risk Cancellation Risk Purchase Price Risk Legal Risk

Musharakah is a partnership agreement between the bank and a customer to contribute capital in various proportions to run a commercial enterprise.

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Risks Inherent in Musharakah

Salam

Capital Risk Capital Impairment risk Entrepreneurial Risk Purchase Price Risk Shariah Compliance Risk Liquidity Risk

A Salam contract refers to an agreement to purchase, at a predetermined price, a specified kind of commodity which is to be delivered on a specified future date in a specified quantity and quality against full payment of purchase price.

Mitigants
RISK Capital Risk CATEGORY Credit Risk MITIGANTS This can be mitigated by conducting extensive feasibility study prior to entry into a contract. By proper due diligence and feasibility studies A partner in Musharakah cannot guarantee the capital of another partner. Due attention should be given to all Shariah related aspects. Only long-term or deposits having same maturities will be used for Musharakah arrangements.

Risks Inherent in Salam

Entrepreneurial Risk Purchase Price Risk Shariah Compliance Risk Liquidity Risk

Business Risk Market Risk

Default Risk Quality Risk Non-performance Risk Price Risk Storage Risk Operational Risk

Operational Risk Liquidity Risk

Liquidity Risk

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Mitigants
RISK Default Risk CATEGORY Credit Risk MITIGANTS A security in the form of a guarantee, mortgage or hypothecation can be obtained. Seller is bound to deliver the goods of exact quality agreed upon, otherwise the buyer may refuse to accept its delivery In case of an adverse situation, to avoid losses, ensure the delivery or promise to purchase from a third party.

Istisna

Quality Risk

Credit Risk

An Istisna contract refers to an agreement to sell to or buy from a customer a non -existent asset which is to be manufactured or built according to the ultimate buyers specifications and is to be delivered on a specified future date at a predetermined selling price.

Nonperformance Risk

Market Risk

Mitigants
RISK Price Risk CATEGORY Market Risk MITIGANTS This can be mitigated by simply entering into a Parallel Salam contract. Same as above Ensure that the relevant staff has gone through appropriate training and has proper knowledge of Shariah principles as well. Accepting partial delivery from the seller so as to generate cash in order to meet liquidity requirements.

Risks Inherent in Istisna

Delivery Risk Default Risk Non-performance Risk Quality Risk Price Risk Order Cancellation Increase in cost of Manufacturing Storage Risk Non-performance of Agent Liquidity Risk Default by Ultimate Purchaser

Storage Risk Operational Risk

Market Risk Operational Risk

Revenue Risk

Liquidity Risk

Liquidity Risk

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Mitigants
RISK Delivery Risk CATEGORY Credit Risk MITIGANTS Istisna price can be reduced on a daily basis to penalize the manufacturer. The banks must obtain sufficient collaterals. The bank can terminate the Istisna agreement and demand the price back from the manufacturer. Khiyar -e-Aib may be exercised and Sub-contractors may be penalized. Parallel Istisna or promise to purchase from a third party. The bank must obtain sufficient collaterals.

Points for Product Design

Key point to have in mind designing Products based on Islamic modes

Need of the Customer Business Cycle / Purchase Process of the customer Tenure of Financing required (Long or Short term) Rate of Financing (Fixed or Variable) Payment Flexibility (e.g. early termination) Type & Nature of Risk Involved and possible ways to mitigate those risks.

Default Risk

Credit Risk

NonCredit Risk performance

Quality Risk

Credit Risk

Price Risk Order Cancellation

Market Risk Credit Risk

Mitigants
RISK Increased cost of Manufacturing CATEGORY Credit Risk MITIGANTS If increased cost due to some external factor price may be increased with mutual consent, otherwise it will be borne by the manufacturer Conducting extensive feasibility study prior to entry into an Istisna contract. Insurance of the goods and minimize the time duration between acceptance of delivery and delivery to the ultimate purchaser A penalty may be imposed to discourage this practice which will further be given to charity The delivery against LC will mitigate default risk since liability of the beneficiarys bank will remain there.

Revenue Risk

Market Risk

Thank you

Storage Risk

Credit Risk

Non Credit Risk performance of Agent Default by ultimate Purchaser Credit Risk

Ahmed Ali Siddiqui Executive Vice President Product Development, Shariah Compliance & Advisory Services Meezan Bank Limited Email: a hmed. ali@ meezanbank.com Tel: +92- 21- 35610607

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