Tuesday, June 29, 2010

Risk Managing An Islamic Bank Beyond Fear of Monetary Loss

Assalamu 'Alaikum
A Risk Management Assignment UIAM Postgraduate Studies in Islamic Banking  and Finance by Muhammad Zahid Abdul Aziz
Identify and discuss the concept of risk management described by the following verses of Al-Quran and Hadiths. Based on the concept you have discussed, give the most appropriate definition of risk and risk management of IFIs:
Surah Ta Ha : Verses 115 to 119
Al-Shu’ara : Verses 60 to 63
Surah Maryam : Verses 22 to 25
Hadiths as described below.
 Using the concept and definition of risk and risk management you have developed; draw up a comprehensive Enterprise-wide Risk Management Framework for a typical Islamic Commercial bank operating in a country you are most familiar with its external and internal environment.

Implication of Surah Ta Ha Verses 115 to119

Surah Ta Ha Verse 115 to 119 basically tells us that Allah created us in the environment of risk. Our Father Adam was created in heaven given a wife and everything he needs but Allah also gives him risk. Risk of disobeying God’s command.
 Man is made weak in nature and always susceptible to risk and hence the first ayah, ayah 115 which says “ We had already, beforehand. taken the covenant of Adam but he forgot: and We found on his part no resolve.” (Ref: The Meaning of the AlQuran by Abdullah Yusuf Ali) This was the first Man created by God and he showed the following features, forgetful and weak.
 This teaches us at least two things already.
 Firstly an environment of risk and exposure to risk is the natural state of Man to exist in, even in his first beginnings in the heavens of Allah. What more when he is thrown down to the Earth the quantity of his risks multiplied.
On top of that Man is naturally forgetful and weak, two features that accentuate his exposure to risk. If Man is in the nature of an Angel for example, risk environment are no danger to him. But weak and forgetful risk is his second adversary next to Iblis.
Ayah 116- When we said to the angels, “Prostrate yourselves to Adam” they prostrated themselves, but not Iblis: he refused.”Iblis and his army of satan is another risk to Man ordained by God even in the Man’s early beginnings in the heavens. Allah created an environment of risk, embodies risk in the nature of Iblis and made Man forgetful and weak thus very much susceptible to risk.
Early on Allah teaches Man about the existence of risk and to manage it. For Man the fruit of his risk management is nothing less than the Kingdom of Heaven.
 If Man does not have needs Man is less susceptible to risk. If Adam did not need Eve he only has himself to manage as a risk exposure. But his need of a wife extends his responsibility of risk management to beyond himself. Other beings expose him to risk also. This teaches Man that living in a society of other beings is also a natural state for him. He has to accept that fact recognise the increase in risk exposure and manage it.
Ayah 117 – “Then we said: O Adam! Verily, this is an enemy to you and your wife: so let him not get you both out of the Garden, so you are landed in misery.” The greatest risk to Prophet Adam and his wife in these early days of Man is the risk of being thrown out of the Garden. Adam needed to manage this risk but his forgetfulness and weakness as a Man failed him.
 Ayah 118 – “There is therein (enough provision) for you not to go hungry nor to go naked.”
 Ayah 119 – “Nor to suffer from thirst, nor from the sun’s heat”
The other basic needs God created for Man is need to have food and to be clothed, and need for water and to be protected from the elements.  These were all provided for Adam and Eve in the Garden. If only they had identified the risk and managed the risk Man might have gone through a different story. But thus have been ordained for Man; Adam and Eve knew of the risks, did not manage it and faced the consequences.
And here we are today. The two ayah also identified the basic needs of Man i.e. food and water, clothes and to be protected from the elements. This teaches us that no matter how far Man have progressed in the World we find ourselves in, Man have to manage the risks of not losing these basic needs. Obsessed with scientific and technological progress modern man is giving less and less thought to agriculture and food production. Exploiting the Earth’s resources relentlessly Man is threatening the continued availability of water for human consumption. Desirous of exotic clothes man’s excessive annihilation of the other species will lead to a disastrous tilt in the balance of nature. An act symbolic of Man’s excessiveness when living life not guided by revelations. Pursuit of material comfort leads Man to manufacture recklessly leading to massive damage to the world’s ecological system leading to Climate change and similar threats to man’s survival. These basic terms in the ayah warns Man of the danger he will face if does not identify the risks he face and manage them early and effectively.
 Definition of risk and risk management to IFI’s that can be gleaned from above verses are as follows:

1)      An IFI have to accept the fact that risks exists in it’s business and have to be managed. There is no business that is riskless except perhaps riba banking. That is why riba banking is abhorred by Syariah. Saiful Rosly (2003) noted that the riskless nature of riba banking “violates the law of nature in Islam since everything except God must depreciate and money is no exception. When money is not subjected to the law of depreciation, man has put money equal to God. In Islamic law this amounts to idolatry (Shirk). For this reason God declared war on Muslims who consume riba.” Once we acknowledge there is risk in Islamic Banking we need to identify them before addressing how to manage the risks. Islamic banking is a business, so there are risks attach to various aspects of the business. What is Islamic banking? It is a business of collecting monies from the public and investing those funds to give a return to the people who have extended the monies. We then need to define in what nature people give money to Islamic banks. Is it in the form of an investment or safekeeping? Truly there is no such thing as depositing money in an Islamic institution and expecting a return. That presumes there is a price for money and the act can be construed as a rental of money which is the theme of riba banking and antithesis to Islamic banking. Monies placed in Islamic banks should never have been described as deposits with all its conventional connotations. They should be described as public investments or public safekeeping. So what are the risks associated with such investments and safekeeps. One main one is the risk of not being able to deliver the cash when required by the Bank’s customers because the cash have been invested in profit and loss earning projects. The question need to be asked then why are investors entitled to withdraw on demand when they agreed it was an investment that surely have a period to maturity. Allowing withdrawal on demand is then clearly seen as an act of aping conventional banking. If the bank needs to have this feature then the akad of safekeeping or wadiah yad dhamanah seems the most appropriate. Then there is a legitimate risk for the Islamic bank to manage; they need to risk manage the liquidity risk of not having enough cash when safekeepers demands to take out their money. That’s the risk on the sources side. The risk on the funding side will entail credit risk when Islamic banks engaged in credit finance. Credit finance have never been considered ‘illegal’ by Islamic Jurists; it is its over usage and abuse which have drawn the massive criticism. With debt or credit finance there will be credit risk or the risk of the counterparty not honouring their commitments. If the Islamic bank fundings is in the nature of equity of Mudharabah or Musyarakah then the Islamic banker need only to address the investment risks.

2)      What is the form of risk management indicated here?

Of course all risks are look at from the point of view of the Islamic bank that is exposed to the risks. If the risks are not managed then the Islamic bank will suffer losses or in the worst case scenario the Islamic bank will have to be closed. All these risks are measured in terms of monetary loss. However Islamic banks are also exposed to a particular risk which are spared or not considered by conventional institutions. This is the risk of a Mukallaf in not obeying the laws of his Maker. There’s a term called Shariah non-compliance risk which is used in Islamic Risk Management terminology. However this risk is usually classified as an operational risk and its loss is measured in monetary terms. The overriding risk faced by an Islamic institution is the risk of incurring the displeasure of his Maker, but who is the Mukallaf here? They need to be humans. In a combination of responsibility we offer that the Mukallaf includes the Shareholders, the Directors, the Management, the Staff and also the Customers of the Bank. The nature of risk management here is to do all things to comply with the requirements of the Law Giver, be it in action, in words or in heart.

Surah AlShuara Verses 60 to 63 and Surah Maryam Verses 22 to 25.

These two surah teaches an element of risk and risk management which will never be taught in conventional knowledge and that is risk management through complete obedience, submission and worship of Allah swt. It teaches how two holy souls in the form of Musa alaihissalam and Lady Maryam conduct their risk management by being the consummate servant of Allah. Following all the rules of the Maker, the Maker guarantees He will take care of those who do so. Musa is a revered Prophet of Islam showered with many favours and mu’jizat of Allah swt. Lady Maryam in her earlier periods of total worship has been served fruits that came direct from Allah swt. This teaches another form of risk management to Islamic Financial Institutions and that is to be true to the teachings and requirements of Syariah in all its business and actions and Allah swt will surely protect the institution.  It need to be said however such institutions have to go beyond adhering to the literal legal rules of Syariah and  achieve the higher platform of embodying Maqasid Al-Shariah. Again we quote Saiful Rosly (2003) “Ethics again takes a back seat making way for legal rules to dominate Islamic banking juristic opinions. As ethics(akhlaq) and law(fiqh) do not seem to mix, the Quranic spirit of justice and mutual aid is compromised to pave way for financing techniques that may look Islamic on the outside only.”
Hadith (narrated by Tirmizi)
A man asked the Prophet s.a.w. “Oh The Messenger of Allah! Should I leave my camel (without tying it) and put trust(depend) on Allah(tawakkal ‘alAllah) or should I tie it then depend on Allah? He (the Messenger of Allah) said, “Rather tie it and then depend on Allah.”
Umar r.a. said, “I heard the Messenger of Allah  said, “If you depend on Allah (Tawakkal ‘alAllah) truly, He will provide you with sustenance the way He provides to a bird, which flies out hungry in the morning, and comes back to nest in the evening with the stomach full.”
 The form of risk management indicated by these two Hadiths
These two Hadiths introduce two aspects of Tawakkal or full reliance and belief in Allah. One aspect is that in daily life one has to follow the rules of the world before placing Tawakkal on Allah. In other words it is wrong to not do what is required in the hope and belief that Allah will take care of us. The way of the world as set by Allah must be followed before we place our Tawakkal to Allah. In conventional discussions on risk management it is recognised there are certain risks which are highly unlikely and it is acceptable for the bank not to provide for it. This discussion usually arises in the context of determining economic capital and what risks can be ignored. Conventional discussions end there. The Islamic discussion will take it further that by introducing the concept of Tawakkal ‘alAllah where in such situation man still risk manages by placing his trust on Allah swt to protect him.
The second Hadith about the rizq of the birds extends the depth of the belief further such that deep beliefs bring the being into a higher level of Tawakkal, bordering on the certainty that Allah will provide. This falls into the same category of Allah guaranteeing the rizq of all newborn lives.
A further lesson of these two Hadiths is that an Institution does not have to provide for every single risk. It is merely expected to do its level best in terms of risk management and it is then valid as a strategy to place tawakkal ‘alAllah.
An Enterprise Wide Risk Management Framework
An Enterprise Wide Risk Management Framework for an Islamic Bank can be drawn up either by looking at each activity of the bank or at the level of humans involved with the bank. To aid us in this effort we present below a comprehensive overview of all the activities of an Islamic bank.
Market Development and Customer Management Process; Capital Market Operations; IT Operations; Shariah Compliance; Corporate Governance, Finance, Accounts, Budget & Funding; Risk Management; Remittances and Correspondence Banking; Administration; Treasury Operations; Delivery Channels; Financing and Credit Administration; Deposits Mobilization; Human Resources and Takaful/Islamic Insurance
Before we begin to discuss the enterprise wide risk management framework we need to take cognisance that the authorities would have set a minimum capital fund for our bank to be maintain at all times. In Malaysia if it is a domestic banking group then the minimum capital fund would be RM2.0 billion. If it is a stand alone bank then the minimum is RM500 million for local banks and RM300 million for foreign banks.
Having achieved that our bank would now need to meet the Minimum Capital Adequacy Ratio as set by our Central Bank which is 8%. This is defined according to the following formula:
RWA funded by restricted PSIA (CR + MR)
(1-) RWA funded by unrestricted PSIA (CR + MR)
 RWA funded by PER and IRR (CR + MR)

Source: BNM Capital Adequacy Framework for Islamic Banks
The Capital base is defined as the permanently available Tier I core capital plus the appropriate portion of the supportive Tier II capital as defined in the Capital Adequacy Framework as issued by Bank Negara Malaysia (BNM). This is then to be divided by the denominator which comprised the following formula
Total Risk Weighted Assets (RWA) which is the sum of credit risk, market risk and operational risk weighted assets
Less/ RWA funded by restricted Mudarabah deposit account holders
Less/ (1-alpha) RWA funded by unrestricted Mudarabah deposit account holders
Less/ (alpha) RWA funded by Profit Equalisation Reserve
Where alpha represents the proportion of commercial risk to be absorbed by the bank arising from the application of DCR.
DCR is the risk of topping up Mudarabah Depositors profit share in times of low liquidity and high deposit returns in order to retain them with the bank
Having settled the capital side of risk for an Islamic Bank we now need to examine what the Islamic bank need to do to contain risks in its daily operations. We will approach this by looking at the entire risk structure of a bank and then address the specific requirements of each area from the point of view of an Islamic bank. An overview of banking risks is provided below:
Financial Risks = Balance Sheet Structure; Income Statement Structure/Profitability; Capital Adequacy; Credit; Liquidity; Market; Currency
Operational Risks =  Internal Fraud; External Fraud; Employment Practices and Work Safety; Clients, Products and Business Services; Damage to Physical Assets; Business Disruption and System Failures(technology risks) and Execution, delivery and process management.
Business Risks = Macro policy; Financial Infrastructure; Legal Infrastructure; Legal Liability; Regulatory compliance; Reputational and Fiduciary; Country Risk
Event Risk = Political Risk; Contagion; Banking Crisis; Other Exogenous.
Bank exposure to risk
Banks are exposed to four broad categories of risks, namely financial, operational, business and events risks. Financial risks are of two types namely pure risks and speculative risks. Pure risk includes liquidity, credit and solvency risks. Banks can lose if these are not properly managed Speculative risks include returns, currency and market price (or positions) risks. Financial risks have complex interdependencies Forex business essentially entails currency risk, but with open positions and mismatches in forward book this attracts liquidity and returns risks as well.
Operational Risks are related to the bank’s overall organisation including internal systems computer related and other technologies, compliance with bank policies and procedures and measures against mismanagement and fraud. Business Risks are related to the bank’s business environment including macroeconomic and policy concerns, legal and regulatory factors, overall financial infrastructure and payment system. Event risks cover all exogenous risks which can jeopardise a bank’s operations or undermine its financial condition and capital adequacy.
 The Islamic bank faces a different aspect of risk compared to conventional banks. This may be illustrated as below:
Specific Risks
Rate of Return Risk, Shariah Non Compliance Risk, Displaced Commercial Risk, Equity Investment Risk
Standard Risks
Credit Risk, Market Risk. Liquidity Risk and Operational Risk
Which risks are defined as follows :
Credit Risk = The potential that a counterparty fails to meet its obligations in accordance with agreed terms and conditions of credit-related contract
Market Risk = The potential impact of adverse price movements such as benchmark rates, foreign exchange rates, equity prices on the economic value of an asset
Liquidity Risk = The potential loss arising from the Bank’s inability either to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses
Operational Risk = The potential loss resulting from inadequate or failed internal processes, people and system or external events
Shariah Non-compliance Risk = Risk arises from the failure to comply with the Shariah rules and principles as determined by the Shariah regulatory councils
Rate of Return Risk = The potential impact on the returns caused by unexpected change in the rate of returns
Displaced Commercial Risk = The risk that the bank may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by PSIA holders.  The bank foregoes part or its entire share of profit in order to retain its fund providers and dissuade them from withdrawing their funds.
Equity Investment Risk = The risk arising from entering into a partnership for the purpose of undertaking or participating in a particular financing or general business activity as described in the contract, and in which the provider of financing shares in the business risk.  This risk is relevant under Mudharabah and Musharakah contracts.
The Risks of Operating in a Dual System
The above risks should now be familiar to most people and much discussed in the literature. I would like to forward one aspect of risk for an Islamic bank that has rarely been discussed or brought to the forefront of public forum, and that is the risk of operating in a dual financial environment. Islamic banking has to start in a dual banking environment; it’s not as if we have a choice. But the choice we have is not to ignore the impact of riba banking on Islamic banking. The greatest risk of this dual system is the risk of turning an Islamic Bank into a replica of the conventional bank in order for the Islamic Bank to survive. When riba is not haram and Islamic and conventional banks have to compete for the same deposits, the rules Islamic banking have to observed can be an unfair advantage in favour of conventional banks. However this does not mean conventional banks produce superior products in spite of not following Shariah rules ; what this means is that conventional banks are allowed to produce defective products for society which should not have been allowed to leave the production line. Factory rejects which are popular in the market would be an apt similitude for conventional products. Islamic banks take deposits on Mudarabah; they have little leeway to response to sudden changes in market liquidity. Conventional banks price deposits on interest; they can adapt quickly to liquidity changes. As a result Islamic banks can be high and dry in times of low liquidity and flooded with unwanted deposits in times of high liquidity. All these forces Islamic banks to replicate in itself the nature of a conventional bank so that it can get the economic benefits. These actions will them bring them into disrepute, entering the dangerous zone of breaching Syariah. Secondly, an Islamic bank may wish to extend financing based on the equity concepts of Mudharabah and Musyarakah. However these financing need to be funded by deposits. Because of the rental of money concept introduced by conventional banking people are used to depositing money short term so the majority of deposits are short term in nature. Islamic banks who want to extend financing based on Mudarabah and Musyarakah will think twice if they are to be funded by short term deposits. What if the depositors wish to withdraw when the projects are always long term in nature? So to be safe Islamic banks will find financing that will deliver to them early returns; hence they will focus on debt financing. Again becoming a replica of conventional banking in order to get the economic benefits. It is about time people recognised these particular risks of Islamic banks and address them in the manner the Law Giver expects us to address them.
Framework of Managing the Risks
There are some risks like the risks of operating in a dual system which Islamic banks cannot manage on their own. They need the understanding of the authorities to change the environment so that these risks become redundant. And if we believe in Maqasid AlSyariah the benefits to this change will not be confined to Islamic banks but will be enjoyed by humankind.
Within the confines of risks that can be managed by Islamic banks the Framework will take the following form :

1)      Established Risk Management responsibility at the highest level of the Bank’s hierarchy.
2)      Set clear Risk Management strategies, policies and operational targets.
3)      Coordinate all decision making in relation to Risk Management.
4)      Clear parameters set on for example requirements on bank customers, single customer limits and operational limits.
5)      Business and portfolio decisions to be based on rigorous standards of analyses
6)      Systematic gathering of data required for Risk Management
7)      Quantitative models and simulations on the effect of changes to the economy to the risk profile of the bank.
Islamic Economics have crossed the divide. Islamic Accounting is on the verge of doing so. Islamic Risk Management must make the jump soon. A Subject is only truly relevant when it cross the divide to take into account the Mukallaf’s fear of the consequences of the hereafter. Islamic Economics have extended all time horizons to the hereafter and so its calculations of risk and rewards. We should not confine Islamic Risk Management only to monetary loss lest we will lose grip of the subject. Risk management of an Islamic Financial Institution must cater for the biggest risk of all and that is the risk of incurring the wrath of the Law Giver. The Risk Management Framework of an IFI must have achievement of Maqasid Shariah as its ultimate objective. Otherwise we will achieve neither; neither the protection against monetary loss nor the achievement of Maqasid. Sometimes we need to realise what seems disastrous in terms of conventional knowledge may actually be the route we need to follow to achieve our true objectives.
  1. The Meaning of the Holy Quran by Abdullah Yusuf Ali
  2. Analyzing and Managing Banking Risk – Greuning and Bratanovic (World Bank)
  3. Performance of Islamic and Mainstream Banks in Malaysia –Saiful Rosly & Afandi Bakar (2003) International Journal of Social Economics
  4. Capital Structure and Risk in Islamic Financial Services – Grais & Kulathunga (World Bank)
  5. Bank Negara Malaysia – Risk Weighted Capital Adequacy Framework for Islamic Banks
  6. Bank Negara Malaysia – Guidelines on the recognition and measurement of Profit Sharing Investment Account as Risk Absorbent
  7. Basel I
  8. Basel II
  9. Islamic Financial Services Board Capital Adequacy Standards for Islamic Financial Institutions
  10. IBFIM

     Note :  Mukallaf : Of age and accountable to Allah swt.
                Maqasid Al_Shariah : Objectives of Shariah
               Rizq : Entitlement in life as ordained by Allah swt (source of food, income, wealth, children etc as   preordained by Allah swt)
              The Maker; The Law Giver = God = Allah swt.
Note: The edited version appears in The Edge Malaysia Aug 9 2010

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