Shariah Compliant Risk Management

Advanced Global Risk Management


Topic: Shariah Compliant Risk Management


Presented by:

Houda Cherrak and Bouchra Touzani



To


Doctor: David Hampton




March 27, 2008
Introduction to Islamic banking system

Islam not only prohibits dealing in interest but also in liquor, pork, gambling, pornography and anything else, which the Shariah (Islamic Law) deems unlawful. Islamic banking is an instrument for the development of an Islamic economic order.
Islamic banking, with 15 to 20% growth a year, has emerged as one of the vital pillars of the global economic system. Islamic financial institutions (IFI) are operating in over 75 countries, managing between $500 billion and $1 trillion assets.

The Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit-and- loss-sharing basis. This by no means implies that investments with financial institutions are necessarily speculative. This can be excluded by careful investment policy, diversification of risk and prudent management by Islamic financial institutions. It is possible, that investment in Islamic financial institutions can provide potential profit in proportion to the risk assumed to satisfy the differing demands of participants in the contemporary environment and within the guidelines of the Shariah. The concept of profit-and-loss sharing, as a basis of financial transactions, is a progressive one as it distinguishes good performance from the bad and the mediocre. This concept therefore encourages better resource management.
Islamic financial industry has come a long way during its short history. The future of these institutions, however, will depend on how they cope with the rapidly changing financial world. With the advent of globalization and informational technology, scopes of different financial institutions have expanded beyond national boundaries. As a result, the financial sector in particular has become more dynamic, competitive, and complex. Moreover, there is a rapidly growing trend to mergers & acquisitions and financial consolidation, which blurs the unique risks related to various segments of the financial industry. Furthermore, there has been an unprecedented development in computing, mathematical finance and innovation of risk management techniques. All these developments are expected to enlarge the challenges that Islamic financial institutions face particularly, as more well established conventional institutions have started to provide Islamic financial products.
Islamic financial institutions need to equip themselves with the up-to-date management skills and operational systems to deal with this environment. One major factor that will determine the survival and growth of the industry is how well these institutions manage the risks generated in providing Islamic financial services.
Developing risk management compliant Islamic financial institutions issues becomes more significant but complex subject. Risk management processes and techniques enable financial institutions to control undesirable risks and to take benefit of the business opportunities created by the desirable ones. These processes are of important concern for regulators and supervisors as these determine the overall efficiency and stability of the financial systems.
Islamic financial services need to strengthen risk management practices in the process of defining their own capital requirements in accordance with their loss tolerant. In fact, IFI could invest in the collection of loss information and adoption of loss data management systems. IFI products would benefit from implementing risk management methodologies and adapting their staffing skills accordingly.
The present paper discusses and analyzes risk management of Islamic Intermediaries. First, it presents an overview of Islamic banking sector. Second, it develops different Islamic financial instruments. The third part shows that the Islamic financial institutions face two types of risks. The first type of risks they have in common with traditional banks as financial intermediaries, such as credit risk, market risk, liquidity risk and operational risk. However, due to Shariah compliance, the nature of these risks changes. In the second part, the paper will explore the second type which is new and unique to the Islamic banks as a result of their special asset and liability structures. Consequently, the processes and techniques of risk identification and management available to the Islamic banks could be of two types, standard techniques which are not in conflict with the Islamic principles of finance and techniques which are new or adapted keeping in view their special requirements. Finally, the paper will be concluded by discussing different Islamic indexes showing the weak impact of the subprime crisis on that index.

I. Types of Islamic finance instruments

There are different types of contracts that can be signed in an Islamic finance institution, taking into account the restrictions of the Islamic law. They can be applied to bank accounts, investments or almost any type of financial instrument as Sukuk for example.

1. Murabaha

Murabaha is the sale of a good to the client at a higher price than the spot price. Indeed, manufacturers and retailers are used to add a certain profit to the factory price of a product or its final retail price. In the Islamic finance world, the margin that is done is justified by the fact that the seller takes the risk of a deferred payment.

2. Ijara

Ijara consists in buying a land or equipment (machine, car…) and then rent it, implying the payment of a fee. It is a leasing where the two parties agree in advance on the duration of the contract and the amount of a fixed fee. The rental is charged when the asset is handed over to the lessee and it is the lessor that undertakes all the responsibilities consequent to the ownership of the assets. Moreover, in case of late payment, there is no penalty charged.

3. Musharaka

It’s a form of business that is concluded between two or several parties through a joint venture. Consequently, profits and losses are shared between the actors that have the right to participate in the management of their business. The parties can agree to a special repartition of profits (taking into account the efforts of each one like the management of the company) but losses are proportional to the capital invested on each one.

4. Mudaraba

Mudaraba is based on the same principles as Musharaka adding a notion of expertise. Indeed, the joint venture is composed by people who come up with the capital and others who have a special expertise or know how. The percentage of profit is fixed at the beginning and is a way of paying the work of people that did not invest in the project. In case of loss, there is a loss of capital for some and a loss of time for the others who brought their expertise.

5. Al Salam

This type of contracts concerns commodities. The purchase of the commodity is perfectly defined in terms of quality and quantity. The good has to be delivered at an agreed date in the future and the payment has to be fully done at the beginning and can’t be sold between the possession and the maturity.

6. Other types of contracts

Given the enormous capital and liquidity held around the world by individuals seeking for Islamic investment opportunities, a large number of equity and real estate funds have been created. However, there are some types of Islamic finance instruments that are allowed by some scholars even if Muslim jurists agree that they should be prohibited. An example would be Bai-al-dain, which consists in a person selling its debt at discount, as we are used to see in the bill of exchange. In Malaysia, Bai-al-dain has been allowed only in a case where a debt is sold on its par value.

In Islamic Finance, equity funds can only hold long positions in the underlying asset which is the main difference with conventional funds that can also be short. Shorting an asset means selling something which is not owned and owning an asset is a necessary condition for sale in Shariah.












II. Common risks faced by conventional and Islamic financial institutions
Islamic banks are considered to be more stable than conventional ones as they are supposed to share profit on both the liability and asset sides. However, in reality, Islamic Banks have fixed income assets but have profit sharing on liability side.

Islamic finance institutions share the same risks as conventional banks but are exposed to additional risks specific to the Shariah compliant products. There are two major types of risks: financial risks and business risks:


Exhibit 1: Financial risks faced by conventional and Islamic institutions


Credit or counterparty risk: In Islamic finance, contracts are mostly short-term and must avoid excessive uncertainty which minimises the risk that the counterparty defaults.

Liquidity risk: a lack of marketability of an investment involves an increase of volatility, an increase between the bid and ask spread. One of the bases of Islamic finance is that the person must own a tangible asset which results in a non existing secondary market. Consequently, a liquidity problem can arise.



Other types of risks:

Operational risk: risk associated with the potential for systems failure in a given market, usually resulting from inadequate internal processes and strategies, people, system or from external event.

Event risk: unpredictable risk due to unforeseen events such as banking crisis, contagion effects and such other exogenous factors.






III. Specific risks of Shariah Compliant Banking Products
Efficient risk management capability is necessary to enable IFI to strategically position themselves in the global market by using their capital efficiently. Weak risk management systems may deprive IFI product’s of the ability to hedge risks, and undermine their potential contribution to the communities they aim to serve. Adequate ressources need to be devoted to risk identification and measurement, as well as to the development of risk management techniques. In this respect, there is a pressing need to combine solid understanding of Shariah law with a good knowledge of modern risk management techniques so as to be able to develop innovative risk mitigation and hedging instruments. An initial step is a clear identification of risks that may arise in the conduct of Islamic financial intermediation. In carrying out their function, banks manage portfolios of assets and liabilities as well as their capital. Accordingly, each asset, each portfolio, and the intermediary as a whole are subject to risks. In general, Shariah compliant banks face all of the same risks as conventional financial institutions, as well as several that are unique to Islamic finance. Unlike conventional banks, Islamic banks share business risks with investors and borrowers. From a risk perspective, the essential difference between conventional and Islamic banking is in the nature of risk sharing.
In fact, the profit sharing model in Islamic banking sector differentiates the nature of risk that the institution faces. This facilitates unbiased distribution of profits and losses between depositors and banks or partners. That is to say, with returns on the depositor's investment offered on a profit sharing basis, they have an equal share in the business risks of the institution.
Actually, financing based on Islamic Shariah law changes the nature of risks faced by Islamic institutions. For instance, while the conventional bank assures fixed rates on deposits, regardless of whether it makes profits or losses, the Islamic bank offers no such guarantees.
In extending financing and raising resources, Islamic financial Institutions face risks similar to those encountered by their conventional counterparts, but with variations due to specific requirements to comply with Shariah. The requirement of materiality of the financing transaction and the prohibition of interest shape the nature of the instruments IFI can use and their embedded risk. The previous feature put constraints on IFI’s ability to manage liquidity, since there are tangible assets which are non-existing in the secondary markets. In addition, the prohibition of extreme uncertainties (gharar) constrains the use of hedging instruments useful for asset–liability management. Furthermore, there may be operational risks in failing to ensure Shariah compliance. Below, there is a table which summarizes different unique risks faced by Islamic Finance Institutions.
Exhibit 2: Risks specific to Islamic Financial Institutions

Type of risk Definition

Commodities and inventory risk Arising from holding items in inventory either for resale under a Murabaha contract, or with a view to leasing under an Ijara contract.





Rate of return risk



Similar to interest rate risk in the banking book. However, IFI are not exposed to interest rate risk as such, but to a squeeze resulting from holding fixed-return assets such as Murabaha that are financed by investment accounts, the holders of which (investment account holders) expect a rate of return risk in line with benchmark rates. An increase in benchmark rates may result in investment account holders having expectations of a higher rate of return.


Legal and Shariah compliance risk Risks associated with the potential for systems failure in a given market; usually resulting from inadequate internal processes and strategies, people, and systems, or from external events. This includes legal and Shariah compliance risk.

Equity position risk in the banking book
Arises from the equity exposures in Mudaraba and Musharaka financing contracts.
Mark-up risk
(benchmark risk) Since IFI do not use interest, they use market rates as benchmarks in pricing their products. Hence, there is a risk associated with the changes to the benchmark rate.

As far as Credit risk is concerned, this latter varies from Conventional banks in a way it changes according to type of the Islamic finance instruments, for IFI it arises in connection with accounts receivable in Murabaha contracts-declining to honor the promise to buy agreement, counterparty risk in Salam contracts- declining to honor the supply on time and quality, quantity agreement, accounts receivable and counterparty risk in Istisna contracts-declining to honor the promise to accept the delivery agreement, and lease payments receivable in Ijara contracts. Actually, the statistical study has shown on average across IFI balance sheets, Murabaha appears to be the dominant mode of financing, followed by Musharakah, Mudaraba and Ijara. Thus the bulk of the financing may still essentially be trade financing, with more limited engagement in profit-sharing assets and leasing. Accordingly, it may still be the case that credit risk is the dominant risk IFI need to contend with.

A major cause of serious financial intermediaries’ potential distress continues to be lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic and other external circumstances that can adversely impact the credit standing of a bank’s counterparties.

It is remarkably the predominance of this credit risk that underlines the Basel II Accord’s recommendations of the three approaches to credit risk assessment for capital adequacy purposes: the Standardized Approach, the Foundation Internal Rating-Based (IRB) Approach, and the Advanced IRB Approach. In various degrees, these approaches provide banks with the opportunity to have their own credit risk assessment methodology contribute to the identification of capital needs. The better equipped a financial intermediary is in risk management, the more opportunity it would have to calibrate its capital needs and use its resources most efficiently, thus strengthening its competitive position. Accordingly, the quality of IFI’ risk management plays a critical role in determining their competitiveness.

In contrast to the previous, there may be a perception within IFI that the most critical risk they face may be the mark-up risk or rate of return risk. In order of importance, it would be followed by operational risk and liquidity risk. While credit risk is the predominant risk most financial intermediaries (whether Conventional Institutions or IFI) deal with, IFI do not perceive it as being as severe as most other risks they identify. In fact, IFI appear to consider market risk as the least serious.

In terms of regulatory oversight and sound banking practices, all banks, whether conventional or Shariah compliant, are subject to rigorous risk management, sound corporate governance, transparency and full disclosure. In this context, many regulations are designed to build upon the existing global standards by incorporating the unique Shariah features that are relevant to IFIs. This ensures their harmonized implementation across different jurisdictions. In real fact, IFI providing Shariah compliant products and services have strengthened their risk management systems, adapted model-based methodologies for rating, credit, market and operational risks as required under Basel regulations. The Basel Core Principles for Banking Supervision and Core Principles issued by International Association of Insurance Supervisors and IOSCO, though primarily designed to provide a framework of international standards for a conventional financial system, are equally relevant for the Shariah compliant financial services industry.

However, IFI could mitigate credit risk thanks to IT applications system. In order to improve its credit risk management, IFI use this technology that allow a better background analysis of every customer, nature of business, credit rating, previous financial records, financial history, and relationship with existing customers at the bank. In fact, the technology platform tracking this data raises alarms to alert stakeholders at the bank at appropriate junctures to ensure Know Your Customer (KYC) compliance. IT applications also provide a comprehensive support for customer identification, black listing of customers, tracking defaulting customers and managing introductions that monitor Customer account activities for abnormalities.

In addition to these specific risks, IFI face other risks among: risk compliance or reputation risk (excluding compliance with Basel II as we discussed earlier), this risk arises from non compliance with Shariah principles that deal more with environmental risk, information risk and settlement risks. Indeed, many financial organizations including IFI have adopted ISO 14000 standards to manage voluntary compliance standards. The latter focuses mainly on the management systems and not about environmental pollution prevention. Actually, it implies outlining clear environmental goals and generating regular performance reports. However, IFI should insist that a corporate borrower is also adhering ISO 14000 Standards to ensure the efficiency of the standards implementation. In fact the standard requires IFI to establish an Environmental Management System (EMS) in order to improve and monitor regulatory compliance, enhance internal management system efficiency, reduce waste, prevent pollution, and improve environmental performance. The comparative advantage of this standard is the fact that it considers not only limited parties (banks and borrowers) but also a wide range of interested parties including competitors, investors, lawyers and regulators and suppliers. As conventional banks, IFI focus on the derived environmental liability through debt and equity transaction more than their own operations. Indeed, poor environmental management by banks' clients may decrease the value of collateralised property and increase the likelihood of fines or legal liability that reduces a debtor's ability to make payments to the bank. This is why, ISO 14000 as an environmental risk management practice is considered among the most efficient guidelines that allow the IFI to protect themselves from lender liability.

IFI have adopted other important approaches and standards: Continuous Linked Settlement (CLS) and ISO 20022 that mitigate settlement risks. In fact, CLS eliminates the risk of paying one currency and failing to receive the other. With CLS, both sides of the trade are settled simultaneously on a Payment Versus Payment (PVP) basis, which makes it almost like domestic payment system. Thanks to CLS, IFI can not only eliminate the settlement risks but also improve their liquidity management, reduce reconciliation costs, and increase trading opportunities. In addition to these standards, IFI have come out with another guideline (ISO 20022) that helps to achieve Straight Through Processing (STP) in financial transactions between financial institutions. The new standard aims at achieving STP by online online-real-time interaction with back end systems and with batch downloads and uploads as well as handling complex messages and business transactions. By complying with ISO 20022 and addressing settlement risks management effectively, Islamic banks have been improving their liquidity and ensuring faster and secure payments.

As far as information risk management is concerned, IFI have given special attention while coping with this kind of risk. In actual fact, to mitigate information risk IFI have complied with new standards which are Control Objectives for Information and related Technologies (CoBIT), ISO 27002 and SAS70. The first new framework has mainly designed to manage risks associated with Information technology. Besides management guidelines, CoBIT provides the business orientation to control efficiently the security aspects of information technology. To improve their information risk management, IFI have implemented ISO 27002 as security standard aimed for implementation in the commercial sector. The standard consists of a broad set of controls considered to be best practices in information security including policies, practices, procedures, organisational structures and software functions. To enhance the auditing guidelines of the Islamic Financial Institutions, the latter have adopted SAS 70 guideline that enables service organisations to disclose their control activities and processes to customers and customers' auditors in a uniform reporting format. In addition, today’s clients clearly heightens the relevance of SAS70 compliance for IFI, this is why using SAS70 model certifies that the financial organizations has a control objectives and activities examined by independent accounting and auditing firm which give IFI more credibility in the financial market.

Realizing the importance of IT guidelines in managing Shariah compliant risks, IFI are using sophisticated applications that manage information risk efficiently through access controls, information sharing only on a need-to-know basis, effective user management, robust information processing capability, good business continuity planning, and well prepared disaster recovery plans. IT applications systems not have been only proved efficiently in reducing the float risk and the uncertainty but also when applying STP, CLS and the automation in the entire business settlement.

Information Technology applications systems can also be deployed to assist the bank in proper identification, assessment and analysis of previous transactions of counterparties. It can also empower banks to send out triggers on delays, monitor delivery and proactively identify potential for non-payment of contractual amounts on due dates.
Dealing with the asset liability management, IT has been proved very useful especially as the tracking of inflow and outflows as well as the operations size becomes larger and complex, which leads to the need for automation for a better liquidity and credit risk management.

Although compliance requires a greater cost to be applied, IFI is still working on complying with more guidelines associated with IT in order to build trust and manage their risk efficiently.

To sum up, due to their unique nature, the Islamic institutions are working on the development of more rigorous risk identification and management systems. To ensure the effectiveness and the soundness of the risk management process, IFI have created a risk management environment that clearly identify the risk objectives and strategies of the institution and by establish systems that can identify, measure, monitor, and manage various risk exposures. IFI also are working to enhance a proficient internal control system. Because of the importance of risk reporting for the development of an efficient risk management system, the risk management systems in Islamic banks were improved by allocating resources for preparing a number of periodic risk reports such as capital at risk reports, credit risk reports, operational risk reports, liquidity risk reports and market risk reports.

Due to its highly relevance, most Islamic banks already use some form of Internal Ratings System that has been strengthened recently by all Islamic financial institutions. In fact, at initial stages of its introduction the Internal Rating System may be seen as a risk based inventory of individual assets of a bank. Such systems have proved highly effective in filling the gaps in risk management systems hence in enhancing external rating of institutions. This contributes to cutting the cost of funds. Furthermore, risk-based management information, internal and external audit, as well as asset inventory systems have also enhanced Islamic risk management systems and processes. With the contribution of a lender of last resort facility, deposit protection system, liquidity management system, legal reforms to facilitate Islamic banking and dispute settlement, uniform Shariah standards, adoption of international standards and establishing a supervisory board for the industry, specific risks faced by the Islamic banks can be reduced. The Islamic financial industry being a part of the global financial markets is affected by the international standards. This is why the Islamic financial institutions have worked to follow-up the process of standard setting and to respond to the consultative documents distributed in this regard by the standard setters on a regular basis.













IV. Islamic Finance indices

1. Dow Jones Islamic Market Indices

The Dow Jones Islamic Market Index (DJIM) was the first Islamic index, created in 1999. A Shariah Supervisory Board of six scholars is elected in order to judge whether an asset is compliant with Shariah law or not. Today, there are more than 70 indices in the Dow Jones Islamic Market family including global, regional, country, industry and market-cap based indices. Here are some examples of major indices:
Global Indices
• Dow Jones Islamic Market Index
• Dow Jones Islamic Market Developed Index
• Dow Jones Islamic Market Emerging Markets Index
Global Industry Indexes
• Dow Jones Islamic Market Consumer Services Index
• Dow Jones Islamic Market Oil & Gas Index
• Dow Jones Islamic Market Utilities Index
Regional/Country Indexes
• Dow Jones Islamic Market U.S. Index
• Dow Jones Islamic Market Canada Index
• Dow Jones Islamic Market Japan Index
Specialty Indexes
• Dow Jones Islamic Market Sustainability Index
The returns listed in the table show the past performance of two Dow Jones indexes over the past 5 years:


Exhibit 3: Average annual total returns
As of 09/30/07 1-year 3-year 5-year
the Dow Jones SM Islamic Fund 21.20% 13.23% 14.60%
Dow Jones Islamic Market USA Index 21.77% 13.30% 14.71%

2. The Dow Jones Citigroup Sukuk

In April 2006, Dow Jones and Citigroup launched an index which measures the performance of global bonds that are conforming to the Islamic law. This Index was set up as a benchmark for investors looking for Shariah compliant fixed-income investments. In 1996, Citigroup had already created a capitalised Islamic Bank, Citi Islamic Investment Bank (CIIB).
In order to be listed in the index, a bond must comply with different criteria. First of all, the bond must comply with both Shariah Law and the standards of the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) for tradable sukuk. Moreover, it must have a minimum maturity of one year, a minimum issue size of US$250 million and a rating of at least BBB-/Baa3 by leading rating agencies.
Exhibit 4: Components of the Dow Jones Citigroup Index



The first observation is that the components of the index are rated A or higher which shows the high quality grade that charecterise the Sukuk. Moreover, the majority of the bonds are short and medium term. Indeed, one of the features of islamic finance instruments is that they don’t have to be risky. The 11 Sukuk represent a total market value of $ 7.74 billions and are mainly from the United Arab Emirates (UAE).

3. S&P Shariah Indexes

S&P has launched five Shariah country indexes: Egypt, Jordan, Lebanon, Morocco and Tunisia.
At the same time, it has also launched three Shariah indexes: The Global Infrastructure, S&P Global Healthcare, S&P IFCI Large-MidCap. The Global Infrastructure takes into account three ranges of activity: energy, transportation and utilities and include 20 companies picked up from the S&P Global Infrastructure Index. As for the S&P Global Healthcare Shariah Index, it is composed of 72 companies from S&P 500, S&P Europe 350, S&P Japan 500 and has an adjusted market capitalisation: $2.1 trillion. Finally, the S&P/IFCI Large-MidCap Shariah Index is built of stocks from emerging market countries as Brazil, Mexico, Poland, Thailand, Turkey…and represent 90% of the market capitalisation of the S&P/IFCI Composite Index.

4. Other indexes
Other organisms such as FTSE or HSBC have developed a wide range of Shariah compliant indexes.
5. Shariah compliant assets and the subprime crisis

In an environment of subprime crisis, banks have reported losses and stocks were not performing. However, Amana fund, a fund that complies with the Islamic law has registered a return of 13% which ranks it in the top 2% of its category. As investing in banks and other companies that charge interests is prohibited by the Islamic law, Islamic funds have paid off this year. Indeed, they haven’t suffered from the mortgage-related crisis hitting the markets since the summer. Two other Islamic funds have performed better than the S&P 500. As far as the Dow Jones Islamic Fund is concerned, it realized a performance of 13.3% when the average income of mortgage-related securities was up to 3.6%.




References


Websites:

http://finance.yahoo.com
http://www.djindexes.com/
http://www.investaaa.com/
www.islamicpopulation.com
http://www.exchange-handbook.co.uk/index.cfm?section=news&action=detail&id=57999
http://www2.standardandpoors.com/spf/pdf/index/102907_shariahnew3.pdf
www.standardandpoors.com/indices
http://www.amanafunds.com/

Articles from http://www.datamonitor.com/:

Citigroup and Dow Jones launch Shari'ah compliant index, March 20, 2006.
Dow Jones Indexes, Citigroup to launch first Islamic bond index, 2006
Dow Jones Indexes And Citigroup To Launch First Islamic Bond Index, March 6, 2006

Other articles and publications:

Arab Bankers Association of North America, Lisa Meyer and A. Rushdi Siddiqui, August 2007
Islamic Law benefits Amana Fund, Wall Street Journal, November 19, 2007
Principles of Shariah Governing Islamic Investment Funds, Al-Balagh Webzine By Justice Mufti Taqi Usmani.
Shari`ah Supervision of Islamic Mutual Funds Yusuf Talal DeLorenzo, September 30, 2007.
Principles Of Shari’ah Governing Islamic Investment Funds By Maulana Taqi Usmani Rulings on Debt Trading in Shariah By Ust Hj Zaharuddin Hj Adb Rahman, June 21, 2006
International Journal Of Islamic Financial Services, vol 1, no 2, Saiful Azhar.