CHAPTER 13:
PRINCIPLES AND BEST
PRACTICES OF RISK LESSON 7
MANAGEMENT SOURCE: IFS 2ND
ED
LEARNING OBJECTIVES
Upon completion of this chapter, the reader should be
able to:
• Understand the risks faced by the financial institutions.
• Understand Islamic perspectives on risk and its
management.
• Understand objectives and strategy of the financial
institutions towards risk.
•Understand the key issues and challenges of risk
management practices of the IFIs.
1. OVERVIEW OF RISK AND
UNCERTAINTY
The Meaning of Risk and its Underlying Principles
• Risk: exposure to chance of coming danger
• Impact of such losses occasioned by market risks may be
reduced through hedging
• In Islamic finance, profit associated with risk
• Several Islamic finance products inherently prone to
risks. Islamic banks exposed to business risk just like
their conventional counterparts
• Islamic banks also face risks associated with Sharī'ah
compliance in Islamic finance transactions
1. OVERVIEW OF RISK AND
UNCERTAINTY
The Meaning of Risk and its Underlying Principles
•The criterion of legality of any return on capital
investment is risk
•Investors have to bear loss if they aim to make
legitimate profits on investment
•Reasonable measures are required to be put in place to
mitigate the effect of any risk
2. ISLAMIC PERSPECTIVE ON
RISK MANAGEMENT
• Risk Management : identification, quantification
and understanding business risks with a view to
undertake necessary measures to control or mitigate
the risk or its impact
• Risk management or risk mitigation technique try to
reduce risk
• The risk management measures applied by IFIs are
either Sharī'ah-compliant or Sharī'ah-based
measures
• All transactions in Islamic finance (debt-based or
equity-based) are associated with risk
2. ISLAMIC PERSPECTIVE ON
RISK MANAGEMENT
Risk Management in Islamic Commercial Transactions
• Avoiding risk with zero profit in business activities
is allowed in Islam through wadiah yad damanah
(savings only deposit)
• Avoiding risk with positive profit is not allowed
because this is equivalent to interest (riba) from
loans
2. ISLAMIC PERSPECTIVE ON
RISK MANAGEMENT
Risk management: IFSB Guidelines and Basel II
Framework-History
• First: Prior to release of IFSB (Islamic Financial
Services Board)guiding principles: Islamic banks and
financial institutions utilized conventional risk
management techniques whilst trying to comply with
Sharī'ah-rules and guidelines
• Second: In 2005, IFSB issued the Guiding Principles
of Risk Management for Institutions (other than
Insurance Institutions) offering only Islamic Financial
Services
• The aim of the new set of IFSB guiding principles was
to complement the existing framework of BCBS
3. TYPE OF RISK EXPOSURES
Risk in Business Transaction
3. TYPE OF RISK EXPOSURES
Unique Risks to Islamic Banking Business
• IFSB-1(Islamic Financial Services Board) identifies the
following six risks that are unique to the islamic
banking business:
3. TYPE OF RISK EXPOSURES
a) Credit Risk
b) Equity / Investment Risk
c) Market Risk
d) Liquidity Risk
e) Rate of Return Risk
f) Operational Risk
3. TYPE OF RISK EXPOSURES
a)Credit Risk
• Definition of Credit Risk
Risk encountered in business transactions when there is
potential for default on the part of a party in meeting its
obligations as agreed in an underlying contract
• Definition applicable to:
Institutions offering only Islamic financial services
(IIFS)
Institutions managing financing exposures of receivables
and leases
Working capital financing transactions/projects
3. TYPE OF RISK EXPOSURES
a)Credit Risk
• Nature of Credit Risk:
A type of banking risk relating to repayment of debt
at the appointed time in accordance with the terms
of the loan
Failure to repay results in loss (a risk for the bank)
Frequent defaults on payments ultimately result in
credit risk to the bank
Complete default in repayment results in loss and
the bank bears credit risk
Credit risk management becomes necessary to
minimize instances of such risks
3. TYPE OF RISK EXPOSURES
b) Equity / Investment Risk
- For listed companies, equity investment is the buying
and holding of shares of stock by individuals/ firms from
listed stock exchange companies in anticipation of
income from dividends/capital gains
- For unlisted companies, equity investment refers to the
acquisition of equity (or ownership) participation in a
joint venture company
• The joint venture arrangement is also called venture
capital investing which is considered to be of higher risk
than the listed companies
3. TYPE OF RISK EXPOSURES
b) Equity / Investment Risk
• Equity investment risk: Risk arising from entering a
partnership for the purpose of undertaking/participating
in a particular financing or general business activity
(described in the contract), where finance provider
shares in business risk
• The risk involved in popular Islamic finance
instruments Mudarabah and Musharakah is equity
investment risk since Mudarabah and Musharakah are:
- Equity-based products
- Based on joint venture through partnership of capital
provider and the entrepreneur
- Both parties of the contract (the financer and the
entrepreneur) undertake to share the business risk
3. TYPE OF RISK EXPOSURES
b) Equity / Investment Risk
• The Nature of Equity Investment Risk is a confluence of
risks connected to:
The entrepreneur or a partner in Musharakah arrangements
The underlying business activity for the partnership
Operational issues
3. TYPE OF RISK EXPOSURES
b) Equity / Investment Risk
• Preventive measures that must be put in place to review
and evaluate risk profiles of potential partner through
(moral hazard) youtube video in week 4:
Careful examination of past records
Quality of business plan
• Proposed business activity
• Human resources involved
• Factors relating to the legal and regulatory environment
that may affect the viability of the investment
3. TYPE OF RISK EXPOSURES
c) Market Risk (also known as systematic risk)
• Natural disaster, recessions, political turmoil, changes in
interest rates and terrorist attacks.
• The volatility of market values of assets results in
market risk, caused mainly by:
Transactions that involve future delivery or deferred
payment such as Salam contract or murabahah contract
The fluctuations in foreign exchange rates lead to
market risk
3. TYPE OF RISK EXPOSURES
c) Market Risk (also known as systematic risk)
• The volatility of market values of assets results in market
risk, caused mainly by:
• Transactions that involve future delivery or deferred payment
such as Salam contract or murabahah contract
• Risk exposure in Salam contract manifests in different
ways:
- Arising in market risk as a result of price expectation
reversal after the bank has earlier concluded a salam contract
for future delivery of the commodity
- the risk that a failure of delivery of the commodity would
leave the IBIs exposed to commodity price risk (in the case
of parallel Salam)
The fluctuations in foreign exchange rates lead to market
3. TYPE OF RISK EXPOSURES
c) Market Risk (also known as systematic risk)
• Ijarah Contract: The owner of an asset leases it to a
client at an agreed rental fee, which is a consideration
for the beneficial use of the underlying asset
• Market Risk is the result of:
default of payment on the part of the lessee due to
price variation. The resultant effect of such default is
market risk
default on the asset delivery by the bank/lessor
3. TYPE OF RISK EXPOSURES
c) Market Risk (also known as systematic risk)
• Ijarah Contract:
3. TYPE OF RISK EXPOSURES
c) Market Risk (also known as systematic risk)
• Ijārah Muntahia Bittamlik (also known as Ijārah wa
Iqtina): is a form of lease contract that offers the lessee
an option to own the asset at the end of the lease period
either by:
Purchase of the asset through a token consideration
Payment of the market value
By means of a gift contract
• Market Risk: the lessee’s default on lease obligations.
The lessor will be exposed to market risk on the carrying
value of the leased asset
3. TYPE OF RISK EXPOSURES
c) Market Risk (also known as systematic risk)
• Foreign exchange contract : exchange of money for money,
regulated and restricted by relevant Sharī'ah rules
• Foreign-exchange risk: risk arising from changes experienced in
currency exchange rates
• An adverse movement in exchange rates will always result in
currency risk or exchange-rate risk
Sudden changes in exchange rates affects:
The value of investment by the IIFS (Islamic Financial
Services)
IIFS that engage in export and import business activities
IIFS that engage in international investments
• IIFS are exposed to foreign exchange fluctuations arising from
general FX spot rate changes
3. TYPE OF RISK EXPOSURES
d) Liquidity Risk
• Liquidity risk: the potential loss anticipated by Islamic
financial institutions arising as a result of insufficient
liquidity to meet normal operating obligations and needs
• Example: investment that cannot be bought or sold
quickly enough to prevent or minimize a loss
Sometimes considered as part of market risks. But for
the purpose of IIFS, liquidity risk is regarded as a
separate risk
• Involves a systemic failure on the part of the financial
institution where it fails to meet expected and
unexpected cash flow needs
3. TYPE OF RISK EXPOSURES
d) Liquidity Risk
• Liquidity risk can be caused by:
Incorrect judgment and complacency
Unanticipated change in cost capital
Abnormal behavior of financial markets
Range of assumptions used
Risk activation by secondary sources
Breakdown of payment systems
Macroeconomic imbalances
financial infrastructure deficiency
Contractual forms
3. TYPE OF RISK EXPOSURES
d) Liquidity Risk
• The IIFS must maintain a stable level of
liquidity in order to:
Regulate the cash flow process
Meet requirements for withdrawals of two
account holders
3. TYPE OF RISK EXPOSURES
e) Rate of Return Risk
• Rate of Return: gain or loss on investment over a
specified period, shown as a percentage increase
over initial investment cost
• Rate of return risk is risk associated with potential
impact of returns of an Islamic financial institution,
arising from unexpected change in rate of returns in
business transactions
If a firm’s returns are lower than market
benchmark rates, they may react negatively and
possibly pull out their funds.
3. TYPE OF RISK EXPOSURES
f) Operational Risk
• Risk arising from execution of business functions of
an Islamic bank
• Causes:
Failures in the internal controls of a financial
institution involving processes, people and systems
Non-compliance with the Sharī'ah requirements
Any failure in the fiduciary responsibilities of the
financial institution towards the IAHs (Investment
Account Holder) and current account holders
Costs: operational risk may lead to withdrawal of
funds by the fund providers and ultimate closure of
accounts costing Islamic banks.
Loss of income, good reputation, business
opportunities
5. IFSB GUIDELINES ON RISK
MANAGEMENT FOR THE IFIs
a) Comprehensive Risk Management
5. IFSB GUIDELINES ON RISK
MANAGEMENT FOR THE IFIs
a) Comprehensive Risk Management
•The risk management mechanisms for Islamic
banks and financial institutions are intended to:
Mitigate
Transfer
Avoid/Elimination
Absorption/Management
5. IFSB GUIDELINES ON RISK
MANAGEMENT FOR THE IFIs
i) Risk Avoidance (is also known as risk elimination)
• Risk avoidance or elimination techniques in Islamic
banks include:
Measures that promote risk avoidance
Approval of Sharī'ah Board of Islamic bank of all
processes, procedures and services rendered by the
financial institution
All business-related documents must be standardized in
line with the requirements of the Sharī'ah and endorsed by
the Sharī'ah Board
All elements of uncertainties (gharar) and undue
enrichment through interest (riba) are excluded from the
contract
5. IFSB GUIDELINES ON RISK
MANAGEMENT FOR THE IFIs
ii) Risk Absorption
• Risks that cannot be eliminated nor transferred must be
absorbed or effectively managed by the Islamic financial
institution
• Risks that cannot be easily separated from the assets of the
bank and its investors must be accepted by the financial
institution because such risks are central to their business
• Credit risk and market risk are the most prominent
• How? Risk absorption techniques include collateral
(security against credit risk), guarantees (supplements
collateral to avoid absorb credit risk), loan loss reserves
and allocating capital
5. IFSB GUIDELINES ON RISK
MANAGEMENT FOR THE IFIs
iii) Risk Transfer
•Risk transfer involves:
The use of derivatives for hedging
Changing borrowing terms and selling or buying of
financial claims
•Risk transfer mitigation techniques include:
Swaps
Forward
Futures
Options
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