risks involved in Islamic Banking

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Risk characteristics of Islamic

financial products

Institute of Islamic Banking & Insurance

London 15th December 2004

Warren Edwardes

Risk characteristics of Islamic financial products

� Institute of Islamic Banking & Insurance

� London 15th December 2004

� Warren Edwardes,

� ceo, Delphi Risk Management Limited

� email: [email protected]

� web: dc3.co.uk



Delphis website contains:

� articles on Islamic banking on:dc3.co.uk/islamicbanking

� This PowerPoint is on:dc3.co.uk/islamicfinancerisk041215.ppt

� with notes on dc3.co.uk/islamicfinancerisk041215.pdf

� Speech drawn from the book "Key Financial Instruments"

� Appendix 1 (50 Risk types)

± dc3.co.uk/risks.htm

� Appendix 4 (Islamic banking)± dc3.co.uk/islamicbanking.htm

Warren Edwardes



financial risk

� some actions can protect

� the same actions can destroy

� risk a film

Warren Edwardes



Warren Edwardes



� Does Islamic banking risk differ from Conventional banking risk?

� Not different - just a very special case±

Trade credit ? ± Asset backed Secured or unsecured ?

± Debt or equity ?

± Leasing ?

± Repos / Murabaha ?

± Fund management ? � Islamic Banking is ALL about who bears risk

Warren Edwardes



A check-list of 50 banking risk types

� To put it simply and directly,

� if the bosses do not or cannot understand

both the risks and rewards in their products,� their firm should not be in the business. -

� William J. McDonough, President, Federal

Reserve Bank of New York

Warren Edwardes



banking risk types - 1-4

� Acquisition Risk

± Different cultures between banks consolidating

� Careless Error Risk

± Human error should be forgiven. But this is not covered by

law

� Competitive Risk

± LIBOR determines competitors returns

� Commodity Risk

± If you take delivery can the commodity price be managed?

Warren Edwardes




� Communication Risk± Define terms clearly

± Deposit or managed funds?

�

Country Risk± much of Islamic banking is carried out in emerging

markets. Riskier? Pakistan is stable in the eyes of Mid Eastinvestors

� Credit Risk±

Not loans. Not IOUs. So equity not loan risk� Cultural Risk

± Difference between Gulf and Malaysia - narrowing

Warren Edwardes



banking risk types 9-12

� Currency Transaction Risk

± use of derivatives generally not allowed? Cannot hedgeexchange rate for purchases

�

Currency Translation Risk± Balance sheet value of dollar assets or liabilities fluctuate

� Currency Economic Risk

± Again no hedging permitted. So can Malaysia compete

with USD based countries when the USD depreciates?� Customer Satisfaction Risk

± If a bank pays no dividends customers will get angry

Warren Edwardes




� Disaster Recovery Risk

± If a terrorist or earthquake strikes can you cope?

� Economic Activity Risk

± Applies when overheads are fixed. Outsourcing a solution

� Energy Price Risk

± Many Islamic countries economies are linked to the oil

price

� Environment Risk

± Are environment unfriendly policies haram?

Warren Edwardes




� Equity Market Risk± Islamic banking is ideally profit and loss sharing. This is

venture capital or equity investment

� Fraud (banker) Risk± Transparency is required. Avoid the risk of

misinterpretation and mis-selling

� Fraud (customer) Risk± If an investor loses money will he seek redress? Of course

if he wins he will not� Fraud (staff) Risk

± Haram for lenders to seek material benefit. BCCI was notan Islamic bank but fraud could occur in Islamic banks

Warren Edwardes




� Image / PR Risk± Something hallal could be deemed haram. Sep 11 was bad

PR for Islamic banks

� Information Risk± Lack of transparency in accounts in many Islamic countries

� Inflation Risk± Securitised asset rises in value but not the repayment

amount which being a cash amount depreciates. Time

value of money?� Interest rate Risk

± This is not a closed economy. If interest rates rise sharplydeposits will flow out. LIBOR linking

Warren Edwardes




� Interaction Risk

± Correlation risk. What happened in New York andBaghdad impacts on KL. Gold standard?

� Language Risk

± Arabic, English, Malay, Indonesian, Urdu? Same wordcan have different meanings.

� Legal Risk± UK, Malaysian, .. Is the bank / customer permitted to

carry out such business?. Ultra Vires issue

Warren Edwardes




� Liquidity Risk± Major problem for Islamic banking is the absence of a

developed Islamic money market.

±

about managing confidence and the liability side± About managing diversification.

� Morbidity Risk± No different from conventional banking. What happens if there

is an outbreak of dengue fever or Anthrax?

� Mortality Risk± Do you have offices in a tall building?

± Would you survive major loss through fire?

Warren Edwardes




� Operational Risk

± Are strong procedural systems in place? Really everythingother than market risks

�

Performance Measurement Risk± Most measures of performance are crude and slavish

adherence to rules can lead to poor real performance

� Political Risk

±

Seizure of assets post Sep 11; boycotts by Western banks� Competence / Understanding

± Are the latest products really understood by the bankssenior management? By the customers?

Warren Edwardes




� Concentration of assets Risk

± A problem for Islamic funds. No tobacco, banking and alcoholstocks can lead to heavy weighting in property and technology

� Concentration of liabilities Risk

± Do you have enough investors or do you depend on one or two?

� Concentration of business type Risk

± Financial supermarket or nimble niche player are both fine. Butcan you reinvent yourself if markets change?

± Can you cope with the entry of HSBC / Barclays / Citibank?� Convertibility Risk

± Deliverability risk under exchange controls

Warren Edwardes




� Property (Real Estate) Risk

± Would asset backing be sufficient in times of a property crash?

� Rating Agency Risk

± Adowngrading or even credit watch can impact on liquidity andthe entire business. Investment grade bonds do not default.

They become junk and then default.

� Regulatory Risk

± A firm operating globally will face different rules

� Religious Risk± A Hallal product may later be deemed Haram. Zero coupon

bonds were once Hallal. Other than Malaysia no Central Shariahauthority

Warren Edwardes




� Resignation Risk± Over dependence on one persons skills and market

contacts?

� Settlement Risk± If there is no escrow account there is settlement risk on

Murabaha and BBA

� Systemic Risk± Financial instability is contagious. Financial systems

are closely inter-linked� Tax Risk

± Do the sale and repurchase transactions face VAT? Incometax or capital gains tax treatment?

Warren Edwardes



banking risk types 47-49

� Technological Risk± Are your fax confirmations going to your customer or a

competitor?

� Transport Risk± traffic jams may have led to cancelled meetings which may

never be rearranged

� Weather Risk± Could you hedge against the weather? KLs 1998 smog and

Kuwaits burning oil fields probably had an adverse impacton employees health.

± Weather derivatives are being traded. Haram? WeatherTakaful?

Warren Edwardes



banking risk types 50

� Zero Risk

� Its impossible to take an unnecessary risk.

� because you only find out whether a risk wasunnecessary

� after youve taken it

� Giovanni Agnelli, President F IAT

Warren Edwardes



Particular Islamic banking risk issues

� Liquidity under developed money market

� Interest rate Risk

� Commodity Risk

� Communication Risk

� Equity risk fund management or banking?

� Operational risk

� Religious Hallal or Haram?

� Language Risk - English, Arabic, Malay or Urdu

Warren Edwardes



Risk Issues In Islamic Banking

Warren Edwardes

risks involved in Islamic Banking

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