Risk management strategies and practices for Islamic banks

MUSCAT — Islamic Banking differs significantly from conventional banking approaches not solely by its nature, but also by way of the challenges it faces due to the complexity of its sophisticated nature, in the form of operational risks.

According to Basel II, “Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and system or from external events”.

However, according to the Islamic Financial Services Board (IFSB), in Islamic banks, operational risk is associated with the loss resulting from ‘inadequate, or failed internal processes, people, and system, or from external events, including losses resulting from Shariah noncompliance, and the failure in fiduciary responsibilities.

Thus the best way for Islamic banks to combat operational risks is to develop risk management strategies and practices said Arsalan Ahmed Qureshi, AVP — Senior Manager, Operational Risk — Risk Management Dept, Al Baraka Bank.

Keeping in line with this definition by the IFSB, simply put, the elements of operational risk exposures, related to Islamic banks are Shariah non compliance risk, fiduciary risk, people risk, technology risk, and legal risk.

According to IFSB guidelines, Shariah noncompliance risk arises from Islamic banks’ failure to comply with the Shariah rules and principles determined by its Shariah Board or the relevant body in the jurisdiction in which the Islamic bank operates resulting in the transaction being cancelled, and inability to recognise income or loss.

Fiduciary risk is the risk that arises from Islamic banks failure to perform in accordance with explicit and implicit standards applicable to their fiduciary responsibilities resulting in the deterioration of reputation. People risk is caused due to the lack of people who are adequately trained in modern financial transactions as well as Fiqh al Muamalat (Islamic law relating to financial transactions).

Technology risk occurs due to the Islamic banks’ inability to capitalise on the use of its technology in different ways.

Finally legal risk may arise from uncertainty in laws, the lack of a reliable legal system to enforce financial contracts, legal uncertainty in the interpretation of contracts, the legality of financial instruments, lack of availability of legal experts, and exposure to unanticipated changes in laws and regulations.

Operational risks are a recent addition to a list of risks faced by financial institutions which can lead to significant losses.

This sees various techniques being applied by these institutions, including Islamic banks, to measure and manage operational risks.

At Al Baraka Bank, Qureshi’s responsibilities are twofold, one as a strategic partner to the business units which involves advising them on risk/ regulatory issues and the best way to identify and manage operational issues.

The second is that of a risk controller setting parameters for risk activities. This makes him an expert on the subject of operational risks, risk strategies, measurement of operational risk capital, operational risk capital charge and tools and practices to combat operational risk — issues that will be highlighted in great detail at the Oman Islamic Banking and Finance Conference 2012.

(Oman Daily Observer / 23 May 2012)

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Alfalah Consulting - Kuala Lumpur:
www.alfalahconsulting.com
Islamic Investment Malaysia:
www.islamic-invest-malaysia.com

Deloitte report: 79% of Islamic financial institutions have established a risk department in last five years

In light of the ongoing global financial climate, most world markets and sectors continue to be adversely impacted, including the Islamic Finance sector, which is currently facing regulatory and practice-related reforms.

A report recently published by the Deloitte Middle East Islamic Finance Knowledge Center (IFKC), entitled 'Empowering Risk Intelligence in Islamic Finance: Managing Risk in Uncertain times', addresses and investigates the important issues in practice and regulation in Islamic Finance in the current market challenges.

The Deloitte report is based on a survey and group of case studies developed during the second half of 2011, on 20 leading Islamic Financial institutions from the Middle East and South East Asia, with aggregate assets of more than $50bn.It also includes several interviews conducted with industry leaders and risk management executives.

The Deloitte Risk Intelligence in Islamic Finance report focuses on the governance and structural aspects of an effective risk management framework in Islamic Finance. It presents new findings in the practice of Islamic Finance risk management that offer guidance to boards in managing risk in troubled times. The report identifies three closely-linked issues: risk governance, regulatory pressures and accountability. It also outlines the challenges faced byinstitutions offering Islamic financial services (IIFS) to develop effective risk intelligence functions. 

"Greater pressure has been placed on financial institutions offering Islamic Financial services to galvanize risk exposure and governance capabilities," commented Dr. Hatim El Tahir,director of the Deloitte Middle East Islamic Finance Knowledge Center (IFKC). 

"Along with the Central Bank of Bahrain, the Bahrain Association of Banks supports all efforts to develop and strengthen Islamic banking and finance in the Kingdom of Bahrain. We continue to promote it at regional and international conferences and in the pages of 'The Bahrain Banker', as well as in the BAB publication 'Handbook of Islamic Banking and Finance," said Mr Robert Ainey, CEO, Bahrain Association of Banks.

The Deloitte report further finds that although the practice of Enterprise Risk Management (ERM) is relatively new in the Islamic Finance sector 79% of the institutions that took part in the survey established a risk department in the last five years. However, only 5% of the IIFS' risk departments were set up more than 10 years ago.

"The complexity of Sharia'a compliant debt and equity instruments has evolved, and the types of risks, issues and investors, as well as market conditions have emerged. These factors combined have made it imperative for IIFS to develop and adopt integrated risk management strategies, in order to protect their businesses and stakeholders," El Tahir added.

The Deloitte survey indicates that 83% of the Islamic Financial institutions surveyed have both a formal risk management function that manages the risk activities, and a risk committee that oversees all risks. Moreover, 87% of the Islamic Financial institutions surveyed have 'management members' on their risk committees.

In terms of accountability for the Enterprise Risk Management program, 32% of the surveyed institutions have indicated that the CEO is accountable for risk; while 27% hold the Chief Risk Officer and 13% hold the Head of Risk Management accountable. Thus, the report suggests that IIFS management and decision-makers should support the risk governance process with subject matter experts for in-depth analysis and adequate selection of risk solutions and strategies.

The Deloitte Risk Intelligence in Islamic Finance survey findings indicate the following key challenges that warrant the attention of Islamic Finance sectorleaders and stakeholders:

• 63% of respondents believe that strong commitmentis required from all of Financial Institutions Boards', Sharia'a Supervisory Boards and Management to improve ERM in IslamicFinance.

• 65% of the institutions offering Islamic Financial Services (IIFS) that participated in the survey are considering the development of an ERM program.

• Only 59% of the IIFS that participated have implemented the Islamic Finance Services Board's (IFSB)Risk Management Standard.

• 63% reported that they have not received anyexternal rating, and less than a quarter of the respondents had considered or received external rating from an Islamic rating agency. This constitutes a real challenge posed to industry participants and standard-setters such as the IFSB, Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), International Islamic Financial Market(IIFM) andthe Islamic International Rating Agency (IIRA), to enforce best practices.

• Creating a risk-aware culture is considered the most(68%) important benefit of ERM. 

• The IIFS lack skilled risk experts, and institutions are required to invest inbuilding capabilities in key risk management pillars -People, Process, Technology and Governance.

• 56% of the group studied has risk management software, and 44% of them lag behind in automation of risk information management.In contrast, 71% of the group surveyed in the Deloitte report has implemented the IFSB's Guiding Principles on Sharia'a Governance. Key causes of Sharia'a compliance risks include non-standardized practices, diverse Sharia'a interpretations, and the lack of enforcement of Sharia'a laws in many jurisdictions.

"Global and regional jurisdictional regulatory reforms are continuing. How this regulation will affect the Islamic Finance sectorand the role of IIFS in the economy is yet to be seen," said El Tahir. "One thing is certain - the traditional operations and management of Islamic Finance will need to change. IIFS around the globe will not only need to deal with risk management but will also need operational effectiveness and a skilled workforce to empower risk intelligence in Islamic Finance," he added.

Responding to these new realities may require effective risk governance. IIFS Boards, Sharia'a Supervisory Boards and executives have an important role to play in providing proactive oversight of risk management and risk strategy. The executive risk officers equally play an important role in coordinating risk management implementation and activities between boards and Sharia'a Supervisory Boards and other business supporting units in the institution.

(Ame Info.Com / 25 April 2012)

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Alfalah Consulting - Kuala Lumpur:
www.alfalahconsulting.com
Islamic Investment Malaysia:
www.islamic-invest-malaysia.com