“Risk Management in Islamic Banking”

September, 2012

Shahin ShayanChairman of the Board

Hoda International Financial Engineering Company

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Original Question● Does Risk Management Exist in Islamic Banking?

“Not as effectively as it should”o Current approaches use Basel II standards without

consideration of the differences between the Islamic and Non-Islamic Banking Risk dynamics

o Due to the above error, most Islamic Banks end up having to carry more capital than it is required

o Islamic Financial Supervisory Board “IFSB” has tried to reconcile this problem by coordinating the necessary issues with the BIS and Basel Committees

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Original Question Revised● Should Risk Management Exist in Islamic Banking?

“Yes, very much so”o Islamic Banking is based on Risk sharing and Participation

contracts on the Asset and Liability sideso Islamic Banks incorporate important Risks as a part of their

operations, therefore Risk Management must be taken seriously in Islamic Banks

o Islamic Banking Risk has some similarities and differences compared to the Non-Islamic Banking operations

o Islamic Banking Risk Management approach must have an EWRM and Holistic view incorporating IFSB proposed standards or specific risks of Islamic Banking, as oppose to the strict Basel II approach

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Islamic Banking Risk TypesIn accordance with Basel II & IFSB Standards

Strategic Risk Financial Risk

Credit Risk (Z, Credit Scoring Systems …) Market Risk (Var Analysis, Duration Matching through

Sukuk Issuance) Interest Rate, ROR or Inflation Risk (Duration Matching)Currency Risk (Var Analysis)Price (commodity, equity………) Risk (Var Analysis)

Liquidity Risk (Var Analysis, LGAP, Sukuk Issuance ….) Operational Risk which which Includes Shariah

Compliance, Other Regulatory Legal Compliances, Fiduciary (امین) and Reputation Risks

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Basel II“Framework”

● Basel II is the second of the “Basel Accords”, which are recommendations on banking laws and regulations issued by the “Basel Committee on Banking Supervision”. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.Source: www.wikipedia.com

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● Basel II final version aims at:– Ensuring that capital allocation is more risk sensitive;– Separating operational risk from credit risk, and quantifying both;– Attempting to align economic and regulatory capital more closely

to reduce the scope for regulatory arbitrage.● Basel II uses a "three pillars" concept – (1) minimum capital

requirements (addressing risk), (2) supervisory review and (3) market discipline. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.

Source: www.wikipedia.com

Basel II“Framework”

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Basel II Capital Standards

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Basel II“Development”

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● Basel II Regulators in most jurisdictions around the world plan to implement the new Accord, but with widely varying timelines

● In response to a questionnaire released by the Financial Stability Institute (FSI), 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015

● The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new system

Source: www.wikipedia.com

Basel II“Implementation Problems”

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● In response to the recent financial crisis, the Basel Committee on Banking Supervision (BCBS) set forth to update their guidelines for capital and banking regulations

● The Basel Committee gave a proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the Basel Committee's reform package is to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy

Basel II“Implementation Problems”

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• Almost from the start of the financial crisis, there has been broad agreement that national and international banking systems needed reform. The Financial Stability Forum (now the Financial Stability Board, or FSB), a global group of regulators and central banks, started developing recommendations on regulatory reform as early as the fall of 2007. Its first findings were published in April 2008, six months before Lehman Brothers failed. Since then, the FSB has continued to develop its recommendations, which are regularly endorsed by the G20 governments

• The Basel Committee on Banking Supervision (BCBS) has translated the FSB’s recommendations into a new regulatory capital and liquidity regime and summarized its work in two consultative documents published in December 2009. The proposal, which many are calling “Basel III” , is likely to establish the rules for European banks for the next decade at least and to set the tone for local regulation in other parts of the world. The regulator aims to finalize the new rules by the end of 2010

Basel III“Framework & Proposal”

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● BASEL III refers to a new update to the “Basel Accords” that is under development. The term appeared in the literature as early as 2005 and is now in common usage anticipating this next revision to the “Basel Accords”. The Bank for International Settlements (BIS) itself began referring to this new international regulatory framework for banks as "Basel III“ in September 2010

● The draft Basel III regulations include: – tighter definitions of Common Equity; banks must hold 4.5% by

January 2015, then a further 2.5%, totaling 7%.– the introduction of a leverage ratio (controlling Bank Leverage Ratio),– a framework for counter-cyclical capital buffers,– measures to limit counterparty credit risk,– and short and medium-term quantitative liquidity ratios

Basel III“Framework & Proposal”

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• McKinsey & Company has done a research in on November 2010 and suggests that the task will not be easy. Barring any mitigating actions, we estimate that banks in Europe and the United States will have to raise about €1.65 trillion of new capital, about €1.9 trillion of short-term liquidity, and about €4.5 trillion of long-term funding. The capital shortfall is equivalent to about 60 percent of all outstanding Tier 1 capital, and the short-term liquidity gap is about 50 percent of all the liquidity that banks currently hold. Banks are already mobilizing to reprice assets and cut costs further. Whatever they do, the new rules are sure to dent their profits. Our analysis shows that these rules could reduce return on equity (ROE) for the average European bank by between 3.7 and 4.3 percentage points by 2019, from the pre-crisis ROE average of 15 percent (pre-tax). Some banks might be hit even harder.

Basel III“Framework & Proposal”

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Basel I, II, III … X“Crazy?”

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Risk Structure in Non Islamic Financial BS

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Assets Liabilities & SE

Total Assets Total Liab. SE

Total Liabilities

Stockholder Eq.

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Risk Structure in Islamic Financial BS

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Assets Liabilities & SE

Total Assets Total Liab. SE

Total Liabilities

Stockholder Eq.

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Size of losses

Freq

uenc

y of

loss

esEx

pect

ed Lo

sses

Unexpected losses fromCredit, Market &Operational risks

Income Capital Insurance

Risk Management – Non Islamic BankSustaining & Managing losses - Lognormal

Worst Case or Catastrophic

Loss“Residual Risk to be accepted by the bank

Shareholders”

Basel II Minimum Capital Requirements

Provisions from Income

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Size of losses

Freq

uenc

y of

loss

esEx

pect

ed Lo

sses

Unexpected losses from PSIA financed assets

Provisions from Income

Capital & Investment Risk Reserves

Unexpected losses from current accountand capital financed assets

Profit Sharing Investment

Account, Capital & Profit Eq. Reserves

Islamic Insurance

Risk Management – Islamic BankSustaining & Managing losses - Lognormal

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Managing Risk Based Capital Requirements According to Basel II

● Example of VAR

Frequency Chart

Required Capital

.000

.007

.014

.020

.027

0

6.75

13.5

20.25

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7.8% 8.3% 8.8% 9.4% 9.9%

1,000 Trials 994 Displayed

Forecast: % of Total

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Managing Risk According to IFSBProposed Standards – Implementation Challenges

● IFSB is not empowered to enforce its proposed standards and guidelines. Therefore, the IFSB relies solely on the voluntary adoption of standards by its members and IIFS

● The prerequisites to implement these standards imply sound understanding by supervisors and regulators of the risks involved in Shariah compliant transactions and how such risks are managed

● Absence of adequate risk-mitigating tools and infrastructure for IIFS or even risk management culture among IIFS.

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Managing Risk According to IFSBProposed Standards – Implementation Challenges

● Assurance that the implementation of these standards will not put IIFS at a competitive disadvantage in particular in terms of huge cost implications, lengthy product development process etc

● The IFSB standards, together with additional guidance notes (from IFSB) being developed on specific aspects of these standards constitute the Basel II & III equivalent for Islamic finance

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Risk Management in Islamic Banking

● Risk Management in Islamic Banking is a complex, multi-dimensional process that must incorporate the following features:1. Have a Holistic approach2. Have a Multi-disciplinary approach3. Have a Quantitative and Qualitative approach4. Have a Centralized and Decentralized Management

approach5. Have a particular focus on the Accounting (AAOIFI) and Risk

issues (IFSB, etc…) related to Islamic Banking operations (ROR, Equity, Fiduciary and Shariah Compliance Risks)

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Conclusion“Islamic”

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● Major Macro and Micro risks faced by Islamic Banks can be managed and reduced more effectively if:

An EWRM approach using IFSB proposed standards (or an emphasis on incorporating specific risks of Islamic Banking through out the Banks), Prudential Judgment, Common Sense and Experience is utilized

A Global Islamic lender of last resort is created Proper Islamic Deposit Insurance systems are activated A Global Islamic Liquidity Management system is created More uniform Shariah standards are implemented More uniform Islamic Accounting & Auditing standards are

implemented - AAOIFI More uniform Islamic Regulatory & Supervisory structures in

coordination with the BIS standards are implemented - IFSB

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Conclusion

● Historically, International Banks have been managing risk through various internal committees such as:

Balance Sheet Mgt. Committee Credit Risk Mgt. Committee Currency Risk Mgt. Committee Compliance & Audit Mgt. Committee Automation Mgt. Committee

● Risk management in modern Banking through Basel II standards, is viewed from a centralized and holistic point of view

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Conclusion“Islamic & Non-Islamic”

● Most international banks manage their risks through a “Risk Management Committee” that is responsible to the board

● The committee’s chief is not an executive manager (could be a full time non-executive board member) of the firm

● The Committee is responsible for: Development of risk management strategy Risk recognition, calculation, monitoring & control policies and

procedures Regulatory & Basel standard compliance issues

Shahin A. Shayan