RISK MANAGEMENT The Challenge Islamic Banking Continues to Grapple with

There is no need to introduce Islamic banking industry which is widely known not only in the Muslim world but also in non-Muslim world. A few decades ago it was characterised as a period of revival. Now, in the current decade, it is characterised as a period of significant innovation. In the period of revival, around three decades ago, intellectuals were busy praising the Islamic banking industry. In those early days, there were few scholars with knowledge of banking and finance. The handful of scholars who had published works on related subjects were without practical experience, having no exposure whatsoever to modern banks and financial markets. In many cases, banks retained scholars based solely on their reputation as authors and authorities on Islamic subjects in general, not as experts or authors of works on finance or related subjects. But as this industry entered the fourth decade in 1990s, intellectuals started realising the shortcomings of this industry, especially when it came to a matter of competition with conventional banking industry. Globalisation of finance and the rapid integration of Islamic finance into mainstream, raise a number of challenges. The main challenge which needs to be addressed in a very subtle manner is risk management.

Risk is inherent in all business activities, more particularly in banking that is mainly concerned with money, the demand, supply, and cost of which are influenced by market conditions, and government and central bank policies. There are also risks caused by changing productivity and value of banks assets, fast innovations of products/services, advancement in technology, etc. Therefore, banks are realising that it is important to evolve sound risk management practices and policies that can provide them with early warning signals to initiate prompt corrective action suiting their own requirement, business profile and risk appetite. As Islamic finance is expanding into mainstream finance such as capital markets and issuance of sukuk, its rapid growth has posed interesting challenges to the industry.

The risk characteristics of Islamic bank’s assets differ in a number of cases from those of conventional banks, either: (i) because of their juristic (shariah) attributes as financial assets but real estate, commodities, or work in process inventories (in case of Ijarah, Salam, or Istisna assets, respectively); or (ii) because they result from financing mode on a profit sharing basis and are exposed to losses (for asset side mudarabah and musharakah). Risk mitigation is affected by shariah restrictions, such as those on guarantees and the use of derivatives.

They are exposed to particular legal risks. In many western countries, the fact that the documentation is new and not well-tested in the courts adds to legal risks. There is also the shariah question of the interaction of commercial law with shariah. If they conflict there is at least the possibility that a defaulting party can try to evade his responsibilities by claiming non-compliance with shariah. What might broadly be called reputation all risk is critically important to an Islamic bank, whose whole business model depends on ensuring shariah compliance at all times. We would expect to see internal audit cover not just classic control but also shariah compliance was adhered to throughout the organisation. To do that, internal audit needs the relevant skills.

Another is that IT risk stems from the fact that Islamic banking is going industrial. This is simply not the depth of software and processing products available. But there are some inherent mitigates to the additional credit, market, and operational risks. First, many products are asset-backed: they have to comply with shariah. This, for example, ought to make sukuk less risky than conventional bonds. Also, the fact that the contract between bank and customer is grounded in ethical considerations makes it less likely that a customer will seek to defraud the bank – or so one would hope.

Bank should clearly define such risks and develop tools and techniques for their timely identification, measurement and also evolve politics/procedures for their mitigation. Bank also has to create an effective independent organisational setup manned by qualified and experienced personnel to look after risk management and audit functions. The AAOIFI (Accounting and Auditing Organization for Islamic Financial Institution) has provided some guidance on the composition and role of shariah committee/board of an Islamic firm in mitigation risks, which is a welcome move to bring consistency in this arena. But, as Hari Bhambra said, in the absence of mandatory implementation of such standards across the Islamic financial services industry the role and responsibilities of shariah committee/board will continue to vary. Some regulators have sought to address this issue through the implementation of AAOIFI governance standards.

Effective risk management requires effective risk management, and for this regulators must understand the products, contracts and services offered by Islamic firms. Islamic finance is subject to some of the risks as conventional finance, including market and credit risk. In certain structure, Islamic firms are also (albeit indirectly) affected by interest rates movements, most notably in mark-up structures. Therefore, regulators have to take a realistic view of actual race to which Islamic forms are exposed in order to provide the most appropriate regulatory and prudential framework. Regulators need also to recognise the same risk which may apply both types of institution; the same risk mitigates are not always available to Islamic firms. The limited availability of shariah compliance risk mitigation techniques and risk instruments to Islamic firms may impede risk management practices, resulting in identified but unaddressed risk.

BANKING RISK EXPOSURE

Source: Hennie Van Greuing and Zamir Iqbal (2008)

Many types of risks may be present in an individual bank (see above table). Financial risks are subject to complex interdependencies that may significantly increase a bank’s overall risk profile. For example, a bank engaged in foreign currency business is normally exposed to currency risk, but it is also exposed to liquidity, credit, and re-pricing risks if it carries open position. Operational risk is defined as the risk of loss resulting from the inadequacy or failure of internal process, as related to people and systems, or from external risks. Business risks associated with bank’s environment, including government policies, financial sector’s infrastructure. Event risks include all types of risks that, if they were to materialise, could jeopardise a bank’s operations.

Islamic banking has survived well despite the obstacles and scepticism of the critics, although it continues to face many challenges. Its future growth and development will depend largely on the nature of innovations introduced in market. The immediate need is to develop secondary money and interbank markets, and to perform assets liabilities and risk management.

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