Risk management in Islamic Banking

By: Jeroen Thij s is the chief risk offi cer at Bank Islam Malaysia.

There are two questions which are often raised when discussing risk management in Islamic banking: 1) Is risk management actually allowed in Islamic banking; and 2) How does it differ from risk management in conventional banking?

As for the first question, the concept of risk is well accepted in Islamic finance but the management of it is sometimes mistakenly thought of as forbidden as parties share in the risk and reward of underlying transaction and the actual outcome is up to our creator. In fact, it is the bank’s fiduciary duty to manage the risks to protect its depositors and shareholders from adverse events because under the Mudarabah contract it can be argued that if the bank has been negligent in protecting the interests of its fund providers, they might not have to share in the loss.

As for the second question, the risk function at Bank Islam Malaysia is modeled around the Swalah (obligatory prayer), the most important constituent of the Muslim faith and one of the tenets of Islam. The basis of Swalah is built upon five important elements: namely niyyah, jamaah, shurut, rukun and qaedah. These elements are transformed into a framework by applying each of them to the five core areas of managing risk: mission and objectives, functional structure, policies and guidelines, processes and enablers, and tools. These are in turn applied to all key risk areas the bank is exposed to: namely credit risk, market risk, liquidity risk,
operational risk and Shariah noncompliance risk.

The process of risk management, such as risk assessment, risk quantification, risk monitoring and mitigation and risk reporting, is exactly the same at an Islamic bank. The actual risks the bank faces are also quite similar as compared to those in conventional banks but there are distinct differences. common risk types such as credit, market, liquidity and operational risks, but there are also unique risks, such as Shariah non-compliance risk, displaced commercial risk and much higher rate-ofreturn risks.

Credit risk
Credit risk, or the risk that a borrower does not perform according to contract, is exactly the same as for a conventional bank with the diff erence that only Shariah compliant fi nancings are allowed, i.e. all fi nancings must be structured according to the principles of Islamic commercial law and nominated Shariah contracts such as Musharakah, Murabahah, Ijarah, etc. In addition, it should not invade any prohibited (haram) activities. Furthermore, transactions must be accompanied by an activity that will generate legitimate income and wealth, thereby establishing a close link between the financial transaction and productive flows.

Hence over-exposure to risk associated with excessive leverage is mitigated. The potential loss for credit transactions in an Islamic bank might be greater due to the fact that it is sometimes difficult to recover the underlying collateral, i.e. the loss given default (LGD) might be larger. There could be partial transfer of credit risks to the profit-sharing investment accounts (PSIA), whose holders share in the profit according to the agreed profit sharing ration but should bear the full loss.

In practice however this might be difficult and often the bank might take the hit in order to protect its depositors. This risk, displaced commercial risk, will be discussed below. Hence there might be a perceived sense of security on some of the underlying credit assets specifically tagged to PSIAs. Lastly, different types of Shariah contracts might create different kinds of risk. For instance under the Musharakah contract, the credit risk might be greater as the financier is also a partner in the business. For instance, it is important to understand that Sukuk (structured under the Musharakah contract), unlike conventional bonds, are not debt certificates or ‘IOU’ instruments. Sukuk are certificates that provide evidence of an investment in either an asset or a project. The return to investors is not fixed or guaranteed but subject to the performance of this underlying asset. Moreover, being a partner in the business, the financier might not be able to undertake regular recovery activities if the Sukuk is impaired.

Market risk
Market risk or the risk of adverse movements in profit rates (closely linked to interest rates), FX rates or equity prices is a generic risk but more complicated at an Islamic bank due to three factors. Firstly, risks are more difficult to hedge due to the unavailability of liquid hedge instruments and available counterparty lines. Even if proxy instruments are used, the bank runs basis risk and wrong-way risk. Secondly, as the secondary market for Sukuk is extremely limited, i.e. there is a lack of liquidity, the risk related to these investments mainly stems from credit quality rather than from market movements.

Lastly, in certain transactions risk can move from market to credit and back to market. A good example is the non-binding Murabahah purchase order. When the underlying asset is in the hands of the bank, it runs market risk on this asset. Once the asset is sold, the risk is transferred to credit risk but if the client for whatever reason decides not to take delivery of the asset (as it is a non-binding transaction), the risk moves back to market risk. That is why banks are reluctant to enter into nonbinding agreements.

Operational risk
The defi nition of operational risk is the same for Islamic banks: the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. This risk category might be slightly more of a problem for Islamic banks than for their conventional counterparts. This is mainly due to the many, often complex contracts involved, the lack of knowledge by staff of underlying Shariah contracts and the fact that systems are relatively new and sometimes not capable of dealing with the specifics of Shariah-based contracts. It is extremely important for an Islamic bank to follow the proper sequence of the contract or akad and to meet the pillars of akad, otherwise a transaction can be voided at a later stage leading to possible losses.

Rate-of-return risk
This risk is similar to the banking book gap risk that a conventional bank runs, albeit significantly higher. Islamic banks
traditionally attract short-term deposits and invest those in longer-term fixed rate assets. Coupled with the fact that hedging is problematic due to the relative unavailability of hedge instruments, the economic value of equity exposure is on average four to five times larger than for a conventional bank. Islamic banks have only quite recently started to price asset contracts against a floating base rate, thereby allowing them to reduce the gap risk over time.

Displaced commercial risk
Displaced commercial risk is the risk of losing depositors due to a situation whereby, in order to remain competitive, the bank pays its investment (or Mudarabah) depositors higher than what should be payable under the actual terms of the contract by foregoing part of its own profit. An increase in benchmark rates may result in depositholders having expectations of a higher return. If the bank is not able to generate that required return from its assets then it will suffer displaced commercial risk.

There are a few smoothing techniques such as profit equalization reserve (PER) or investment rate reserve, but these are quite controversial. In fact there are parties in Malaysia that are lobbying hard for Islamic banks to abolish the PER altogether, although the Shariah board of the AAOIFI and the Shariah Advisory Council of Bank Negara Malaysia allow its practice. This would
be a major challenge for an Islamic bank; not only in the situation as just described, but in other potential scenarios. What if, for example, the bank had a major recovery from a bad account in a certain month? It would then have to pay out a significantly higher rate than the previous month.

Shariah non-compliance risk
The most important of all risks in an Islamic bank is of course Shariah non-compliance risk or the risk of loss of revenue due to non-observance of the tenets, conditions and principles espoused by Shariah. Non-compliance creates reputational risks. This is because many of an Islamic bank’s customers bank with it out of religious principles and the subsequent loss of trust could lead to a potential liquidity crunch.

Furthermore, income generated from non-Shariah activities cannot be recognized, hence the potential for loss of income. Another risk is that contracts could be challenged in court leading to legal losses apart from the monetary loss of voiding the original contract.

Conclusion
This article was writt en with the Malaysian banking environment in mind. The Malaysian banking landscape consists of many Islamic banks/windows and conventional banks and this dual environment create unique competitive pressures for Islamic banks. There is thus not much diff erence between products off ered by Islamic banks and their conventional counterparts. Risk management in an Islamic bank in Malaysia is also therefore very similar to risk management in conventional banks.

In other countries, such as Pakistan and Sudan, Islamic banks offer more equity based Musharakah and Mudarabah financing thereby creating a much stronger link between the underlying transaction and profi t-sharing.

In Malaysia there is an increased pressure on Islamic banks to move more towards equity-based fi nancing. However, this is not that straightforward. First of all clients do not demand these kinds of structures here as they are reluctant to have a bank as an equity
partner; and secondly these structures require a higher capital charge of 150% making it potentially more expensive for the customer.

Also, focusing on equity-based financing would put additional challenges on a bank in terms of risk management. As the return and potential loss is now much more dependent on how well the underlying project or business is managed, risk officers of the bank would need to have as much knowledge about the underlying business as the business itself. It is quite unlikely that this asymmetry between the capital provider (usually the bank) and the entrepreneur (the client) could be dealt with effectively.