Pre-Examination Session

Class Review
IB2002 Risk Management for
IFIs

Prof. Saiful Azhar Rosly, Banking

Department
INCEIF
 Risk Management
Risk management is a continuing
process of corporate risk reduction

Risk management is about how firm

actively select the type and level of risk
that is appropriate for them to assume.

Risk management and risk taking are

two sides of the same coin.
Business risk
Potential loss in the world of business due
to uncertainty about:
1.Demand for products
2.The price that can be charged for those
products
3.The cost of producing and delivery the
products
Risk is potential loss
Risk itself is not an evil thing
Avoiding risk with zero profit is allowed
Wadiah Yad Dhamanah deposit
Avoiding risk with positive profit is not
allowed interest from loans.
Avoiding risk is an evil action if it injures
the counterparty interest from loans
Risk Management in Islamic
Banking
Fundamental principle in Islamic business :
a. no reward without risk al-ghorm bil
ghonm
b.With profit comes liability al-kharaj bil
daman.
. Risk taking behaviour as the above
risk > 0, profit > 0 permissible
. Risk avoiding behaviour risk =0, profit
>0 - not permissible
 2 dimensions of
Islamic bank risk
management

Profitability
(Making profit with Financial stability
risk)

Banking book Basel II

Trading book
IFSB

Credit risk
Market risk, Market risk 1. Capital Adequacy
operational risk
Liquidity risk Operational risk 2. Supervision
Legal risk 3. Market discipline
RoR, DCR,
Shariah risk
Profitability vs Financial
Stability
Banks as profit-maximizing firms cannot be
left alone without proper regulations by
authorities.
Banks may take excessive risks and
overlooked safety of depositors fund,
eroding capital and thus jeopardizing public
confidence.
Thus in making profit, banks may introduce
financial instabilities.
The purpose of regulation is to instill
financial stability by controlling banks
behaviour.
 Loss Financi
Reduc
due Reduc al
e Bank
Risk e Instabil
Earnin Failure
exposu Capital ity
gs
res
 Capital
Unexpec Insolvent Credit Recessio
Depletio
ted Loss Banks Crunch n
n
5 Basic Shariah Principles in
Financial Transactions
#1 Prohibition of Riba

#2 Application of Al-Bay

#3 Avoidance of Gharar

#4 Prohibition of Gambling(Maisir)

#5 Prohibition of Impure
Commodities
 Efects of Exposure due to Systematic
and Unsystematic risks
Monitoring
Risk Mitigation
Pricing
Position
Risk premium Take
Security
Diligence
Credit Scoring
PD, LGPD
& Due
Business Plans
Cash Flows
Appraisal
Management Process
Islamic Bank Risk
Risk Management

Take Position: Risk-Taking

Impact on Firm

OPTIONS OF RISK MANAGEMENT

Risk
Risk
Prevention/Reduction/ Risk Transfer
Avoidance Mitigation

Insurance
Derivatives
 Islamic
Banking

Shariah Commercial
Aspects Aspects

Shariah Business
Compliance Strategy &
(Products) Profitability
Risk &
Corporate Capital
Governance Managemen
t

AMLA
Failures of Risk Management
Long-Term Capital Management (LTCM)
Enron
WorldCom
Global Crossing
Parmalat
Lehman
Morgan Stanley
AIG
Bears & Stearn
Northernrock
Washington Mutual
More coming soon subprime world crisis
Islamic Banks Average Balance
Sheet
Asset Liability
Cash Wadiah Dhamanah
Current Account
BBA Home Financing Wadiah Dhamanah
Savings Account
AITAB Car Financing Restricted Mudarabah
Account
Bay al-Inah Personal Unrestricted Mudarabah
Financing Account
Enterprise Financing
Government Islamic Commodity Murabahah
Securities Negotiable Islamic
Certificate of Deposits
Sukuk
Fixed Assets Shareholders Capital
Income Statement
Reward comes with Risk
Islamic Banking

Profit and Loss

Revenues $500m
Cost of Funds $200m
Gross Profit $300m
Overheads $80m
Provisions for NPF $10m
Profit Equalization $10m
Reserve
Profit Before Tax and $200m
Zakat
Tax and Zakat $60m
Net Profit $140m
 Credit
Risk
Rate
of Return Market
Risk Risk

Islami
c
Banki
Shariah
Risk
ng Liquidity
Risk Risk

Displace Operatio
Commercial nal Risk
Risk
 Peculiar Risks
Common Risks 1. Rate of
1. Credit risk return risk Total Risks
2. Market riks 2. Displaced faced by
commercial Islamic Banks
3.Operational
risk risk
3.Shariah risk
Comm
on Peculiar Risks
Risks
 Profit
Equalization
Reserve

Displaced
Commercial
Risk

Rate of Return
Risk

Market Risk
(Negative Income gap)
 SHARIAH RISK

Foreclosure & civil court

decision concerning validity
of Islamic banking products

Default

Credit Risk
 Risk

Banking
Trading Book
Book
Eg. Sukuk
Eg. BBA
 Risks in BBA
Financing

Shariah Risk Operational

Credit Risk Market Risk Risk
Recent Court
Low credit Negative Gap Judgement Conventional
Conventional
scoring for can mean losses on solution/system not
solution/system not able
able
Islamic as murabaha/BBA as
to
to accomodate
accomodate Islamic
Islamic
accounting
accounting principles
principles
customers, Interest rate non bona fide leading
leading to
to
higher probability increases sale overcharging
overcharging and
and
undercharging
of default undercharging
customers.
customers.
(PD)

High NPF and Earning at risk Litigation Costs Increase

Write-Ofs (EAR) Erosion of
Capital at risk
Overheads
Capital earnings
(EAR) Litigation costs
Depletion
Risk-taking
Once the bank accepts the risk, it must manage it.
What are the risks faced by an Islamic bank?
The Islamic banks shareholders face the following risks:
1. Credit risk
2. Market risk
3. Liquidity risk
4. Operational risk
5. Commercial displacement risk
6. Rate of return risk
7. Shariah risk
. Losses arising from risky financing facilities will
adversely afect deposits and shareholders capital.
. The objective of banking regulation (Basel II) is to
protect deposits.
. When losses wiped out banks capital, the bank becomes
insolvent.
Risk Management in Islamic
Banking
Concept of risk in Islam
Risk in trading and commercial transactions (al-bay)
Risk in loans
Types of risk
Systematic , pure and speculative risk
Unsystematic
Islamic Banking business
Operates under Basel II
Basel II to protect depositors fund
Capital adequacy requirement
Risk management
Before bank approves financing facilities, it:
Identify risk
Measure risk
Pricing
Risk mitigation
collateral
risk transfers via derivatives
 Islamic Banking Balance
Sheet
Asset Liability
Risk Weight
Murabahah $6000m 1.00 Wadiah dhamanah $2000m
Ijarah $2000m
1.50
Mudarabah $1000m Mudarabah investment deposits
2.00 $8000m
Musharakah $1000m
2.50
Others $500m
0.5
Capital ratio = Eligible Capital / Risk-Weights Assets (RWA)
= $?m/RWA
Eligible Capital = Capital ratio x RWA
Capital ? CAR = 10%
= 0.1 / (6000 x 1) + (2000 x 1.5) + (1000 x 2.0) + ($1000 x 2.5) +
($500 x 0.5) =______?
Highly risky assets carry high conversion factor (Risk Weight)
Islamic bank must carry more capital in order to conduct risky business.
Risk / Potential losses
Murabaha : sale with installment
payments
Credit risk
Shariah risk
Ijarah: financial leasing leasing
ending with sale
Credit risk
Market risk
Shariah risk
Partnership: profit-sharing
Market risk
Operational risk
Islamic Banking

Profit and Loss

Revenues $500m
Cost of Funds $200m
Gross Profit $300m
Overheads $80m
Provisions for NPF $10m
Profit Equalization $5m
Reserve
Profit Before Tax and $200m
Zakat
Tax and Zakat $60m
Net Profit $140m
Credit Risk
Credit risk

Credit risk is the risk that a change in the

credit quality of a counterparty will afect
the value of a security or portfolio.
When counterparty defaults, the bank
loses either all of the market value of the
position or, the part of the value that it
cannot recover.
a. Expected loss (LGD loss given default)
covered by provisions
b. Unexpected loss covered by capital
 Islamic
Loss due to Banks that
Credit risk is thrived on
inevitable Credit
Financing
 Basel II and Credit Risk

Expected
Unexpect
Loss
ed Loss
(Covered Total Loss
(Covered
by banks
by
provisions
capital)
)
 Rising
Loss Non- Financia
Reduce Capital
due Performi Bank l
Earning Depletio
Credit ng Failure Instabili
s n
Risk Financin ty
g
 Credit Risk Management
Adverse selection and moral hazard
Moral hazard exists because borrowers
may have incentive to engage in
activities that are undesirable from
lenders point of view
In such situations, it is more likely that
the lender will be subject to the hazard
of default
Banks have to overcome the adverse
selection and moral hazard problem that
make loan defaults more likely.
 Credit Risk Management
This is done by
Screening
Monitoring & enforcing restrictive
covenants
Establishment of long term
customer relationships
Loan commitment
Specialized lending
Collateral and compensating
balance requirements
Credit rationing
 Total Loss

Expected Unexpected
Loss Loss

Largely due Largely due

to to
unsystemati systematic
c risk risk
Credit Risk in BBA
The risk of the facility is characterized by:
1.The external and /or internal rating
attributed to each obligor, usually mapped
to probability of default (PD).
2.The loss rate given default (LRGD) and
EAGD of the facilities. LRGD is the loss rate
when the borrower defaults.
3.Exposure at given default (EAGD) : notional
value of a loan, or exposure for loan
commitment. Amount of credit outstanding
at the time of default.
Example: Expected Loss
Zahidi Bank hold a $500 million BBA portfolio
with 15 years tenor.
PD of the portfolio = 10%
BBA defaulted after 5 years
Exposure at given default (EAGD) = $400
Collateral $300m
Loss rate given default = (EAGD collateral)/
$500m = ($400m - $300m)/$500m =
($100/$500) x 100% = 20%
EL= PD x EAGD x LRGD
EL = 0.1 x $400m x 0.2 = $8 million
Bank will put aside $8 million for NPF
provisioning.
 EXPECTED LOSS = PD x EAGD x LRGD

EAGD = $400m

Origination Default Maturity

PD = 10%

BBA PORTFOLIO = $500m

Expected Loss is covered by
Banks Provisioning
General
and
Specific
Provisions

Expected
Loss (EL)

Loss Rate Exposure

Probability
Given at Given
of Default
Default Default
(PD)
(LRGD) (EAGD)
Credit risk inn BBA
Expected loss (EL) is the basis for the
calculation of the banks allowance for BBA
losses, which should be sufficient to absorb
both specific and general credit related
losses.
EL can be viewed as cost of doing business.
That is, on average, the bank will incur a
credit loss amounting to EL.
However ACTUAL credit losses may be
higher or lower than EL.
The variation for credit losses beyond EL is
called unexpected loss (UL).
UL is the basis for the calculation of
economic and regulatory capital.
Assessing credit exposure
Compute EL
Compute UL
Determine the volatility of expected loss of
a BBA to the whole portfolio.
Calculate the probability distribution of
credit loss for the portfolio and asses the
capital required to absorb the unexpected
losses.
 Pricing, Credit risk and
Expected Loss

How does an Islamic bank pass on

the cost of non-performing financing
provisions to the customers?
Pricing of Debt instrument.
Profit rate = Cost of deposits + cost of overheads
+ risk premium
Cost of
Deposit
s

Banki
Risk-
Premiu
ng Overhe
ads
ms
Produ
cts
Statuto
ry
margin
s
Banks contractual loan rate is equal to the:
a. cost of deposits (rd),
b. operating costs (c),
c. Statutory profit margin (p) and
d. a risk premium.

. If we take away the risk premium, we get the

targeted interest-rate (rt), which is also known as the
prime or base-lending rate (BLR).
. The BLR is the interest rate charged to banks best
customers consisting of the interest rate on deposits
(rd) operating cost (c) and a profit margin (p).
Based on the above rt = rd + c + p.
Lets say that bank pays depositors 7% and
incurred 1% in operating cost and a 2%
profit margin.
The targeted interest rate is therefore 10%.
Now the bank receives a $180,000 BBA
application from Salim. After full
assessment of his credit ratings, the bank
felt that Salim has a 20% default risk (p d =
0.2).
This also implies that the probability of
Salim making full payment is 80% (pf).
Given this information, the question now is
how much should the bank charge Salim for
the $180,000 BBA?
Or what is the contractual profit rate (r c)?
The contractual profit interest rate is the
rate set in the BBA contract in arriving at
the selling price (SP).

Given that Salim is a risky customer, the

bank may not want to charge him the
prime rate. The prime rate is the rate the
bank charges to its best customer.
Certainly now, the contractual profit rate is
expected to be higher than the prime rate
or BFR.
To obtain the contractual profit rate, the bank
must first determine how much profits it desires
to make from the BBA. Meaning that the
expected rate of return (re) must be computed
to find (rc).
Since the banks targeted rate of return (rt) is
equal to the BFR, it also means that expected
rate of return (re) must be equal to the targeted
rate of return (rt).

rt = re
Now given Salims 20% probability of
default, which is assumed to cause the
bank a 10% loss (rd), [also known as loss
rate given default LRGD in a BBA portfolio]
the expected rate of return (rc) and
contractual profit rate are given below:

Computing the Contractual profit rate (rc) on a Risky BBA

re = (pf x rc) + (pd x rd)

re = (0.8 x rc) + (0.2 x -0.1)

rt = rd + c + p

Since rt = 10% or 0.1

= 0.8rc - 0.02
rc = (0.1 + 0.02)/0.8 = 0.15 or 15%; r c rt
We can see in the above illustration that the pricing of BBA
has included the credit risk factor. It has also added earlier
the time-value of money factor.
Profit rate = cost of GIA deposit (TVM) + OVH + credit risk
the contractual profit rate (rc = 15%) is higher that the
targeted rate of return (rt = 10%). This is simply because
Salim is a risky customer thus was charged 5% higher than
the banks best customer(s) who by definition have no
credit or default risk at all.
In other words, for risky borrowers, the contractual profit
rate is set above the targeted rate.
Likewise, the lower the default risk, the lower is the
contractual profit rate relative to the targeted rate.
Why is this allowed BBA and disallowed in loans?
Credit Risk Premium and EL
Based on the calculated contracted rate of
return (Rc), it is found that the bank
charges an extra 5% based on the credit
worthiness of customer.
This 5% risk premium is used by the bank
to cover the Expected Loss or the
expenses on BBA loss provisioning.
 Islamic Banking

Profit and Loss

Revenues $500m (Rc x F)
Cost of Funds $200m (Rd x D)
Gross Profit $300m
Overheads $80m
Provisions for NPF $10m
Profit Equalization $10m
Reserve
Profit Before Tax and $200m Risk premium is
Zakat used to pay for
unexpected loss (UL)
Tax and Zakat $60m or NPF provisioning.
Net Profit $140m

Rc = cost of deposit + overhead + risk premium

Market Risk

Profit-rate risk
Rate-Sensitivity of Islamic
Banking Products
Impact on Earnings
Market risk
Risk measurement
in Banking Portfolio

Banking Book
Mortage Trading Book
Hire Purchase Bonds
Corporate
Bonds

Earning at Risk
Value at Risk
Income Gap Analysis

Impact on income from changes in profit-

rate
GAP = Rate sensitive assets (RSA) Rate
sensitive liabilities (RSL)
Change in income = GAP x (change in profit
rate)
Income Gap Analysis
Fixed rate asset
(FRA)
1.BBA(F)
2.AITAB Fixed rate liabilities (FRL)

1. CMD (Commodity Murabaha)
3.Tawaruq PF 2. NICD
. Variable rate liabilities (VRL or
. Flexible rate RSL)
asset (VRA or 1. WAD
2. PSIA
RSA) 3. INI
1.Mudarabah
2.Musharakah
3.BBA(V)
Salam Bank Balance Sheet
Asset Liability
BBA $700m Wadiah Dhamanah
$200m
AITAB $400m
PSIA $800m
Tawaruq PF
$100m CMD $250m
Mudarabah $
50m
Fixed Asset $ 100m

Capital $100m
GAP = $50m - $1000m = -
$950m
FRA RSL
1. BBA $700m 1. WAD $200m
2.AITAB$400m 2. PSIA $800m
3. Tawaruq $100m
Total $1200m Total $1000m
RSA RSL
1. Mudarabah $50m 3. WAD & PSIA $1000
GAP = -$950 GAP = -$950
If profit rate decreases If profit rate increases
by 1%, then net by 1%, then net
income will increase income will fall by (-
by (-$950m x 0.01) $950m x 0.01) =
= $9.5m $9.5m.
To make GAP = 0
Increase RSA
Decrease RSL

But to decrease RSL will mean adding more

fixed rate deposits (FRD).
FRD = CMD, NICD.
When GAP = 0, any changes in profit
rate/interest rate will not afect income.
How to mitigate interest-rate
risk in Islamic banking?
Ofering Floating-Rate BBA products
BBA securitization
Profit-rate Swap (PRS)
Floating Rate BBA/Murabaha
Islamic Bank expects interest rate to increase.
Set up the maximum rate
Market rate = 5%
Maximum rate = 10% (based on banks forecast)
Cost of asset = $200,000
Tenure = 10 years
Aqad price = $200,000 + ($200,000 x 0.1 x 10) =
$400,000
Monthly payment = $400,000/120 = $3333.
Selling price based on current rate = $200,000 +
($200,000 x 0.05 x 10) = $200,000 + $100,000 =
$300,000
Monthly payment = $2500 = Actual payment
Rebate = $3333 - $2500 = $833
Floating rate BBA/Murabaha
If rate increases to 6%, SP = $200,000
+ ($200,000 x 0.06 x 10) = $200,000 +
$120,000 = $320,000
Monthly payment = $2666
Rebate = $3333 - $2666 = $667

Islamic bank able to adjust the rate

since the aqad price remains the same
based on the capping rate of 10%.
As interest rate increases, rebate
decreases.
 Interest Rate Swap (IRS)
Fixed rate@Loan
10% @ Loan

Bank A Bank B

Floating rate@Loan
BLR +1 @Loan
Bank A expects interest rate to increase
Bank B expects interest rate to fall
Actual thing: interest rate increases
Loan = $100m
1. Fixed Interest payment = 0.1 x $100m = $10
2. Floating interest payment = 0.12 x $100 = $12 million
3. Bank B pays Bank A $2 million.
4. No exchange of notional loan amount between Bank A and Bank B.
 Profit Rate Swap (PRS)
Fixed rate@BBA
10% @ BBA

Bank A Bank B

Floating rate@BBA
BLR +1 @ BBA
Bank A expects interest rate to increase
Bank B expects interest rate to fall
Actual thing: interest rate increases
Loan = $100m
1. Fixed profit-rate payment = 0.1 x $100m = $10
2. Floating profit rate payment = 0.12 x $100 = $12 million
3. Bank B pays Bank A $2 million.
4. No exchange of notional BBA amount between Bank A and Bank B.
Profit Rate Swap (PRS)
Stage 1 Sells asset in cash ie. notional

Bank A Bank B

resell asset @ notional + fixed rate

Pay fixed rate

Bank A Bank B
Profit Rate Swap (PRS)
Stage 2 Sells asset @notional + floating rate (credit)

Bank A Bank B

resell asset @ notional (cash)

Pay floating rate

Bank A Bank B
Relationship between Market
Risk and Displaced Commercial
Risk
-ve Gap Market risk RoR
RoR DCR
DCR risk mitigation PER
 Profit
Equalization
Reserve

Displaced
Commercial
Risk

Rate of Return
Risk

Market Risk
(Negative Income gap)
Commercial displacement risk
(DCR)
Deposits
Expected rate of return < realized rate of
return
Customers may switch from Islamic
deposits to conventional deposits
To prevent deposit migration, Islamic bank
uses its own reserves to top up the deficit.
Total earning/profit declines.
Gap Analysis
Gap = RSA RSL
Positive Gap: RSA > RSL
Positive Gap: (RSA/RSL) > 1
Negative Gap: RSA < RSL
Negative Gap: (RSA/RSL) < 1

Credit based (Murabaha) Islamic bank:

Most assets are fixed rate asset (FRA) or
RISAs
Most liabilities (Wadiah&Mudarabah) are
RSLs.
Islamic bank faces Negative Gap ; RSA < RSL
Gap Analysis

Gap = RSA RSL

Positive Gap: RSA >
RSL
Positive Gap:
(RSA/RSL) > 1
Negative Gap: RSA <
RSL
Negative Gap:
(RSA/RSL) < 1
Deposits

Wadiah Dhamanah Variable Rate

Mudarabah PSIA Deposits

Commodity Murabaha
Fixed rate Deposits
NICD

Capital
Financing
Musharakah Variabale Rate
Mudarabah Assets

BBA
Fixed Rate Assets
AITAB

Capital
Islamic Banking Realities:
Negative Gap Asset-Liability
RSA < RSL

Fixed Rate
Deposits
Fixed Rate
Assets Variable Rate
Deposits
(RSL)
Variable Rate Assets
(RSA)
BBA Intensive Islamic Banks

Most assets are fixed rate asset

(FRA) or RISAs

Most liabilities
(Wadiah&Mudarabah) are RSLs.
Islamic bank faces Negative Gap ;
RSA < RSL
 Reserve
Amount appropriated out of total income to main an
acceptable level of return on Islamic deposits.
Serve to smoothen return on Islamic deposits (RoID).
Equalization
Increase PER provisions when RoID not competitive.
Profit
Risk
Potential loss that occurs when Shareholders Funds are
Commercial
utilized to smoothen rate of return on Islamic deposits. nt
Displaceme
Potential loss arising from loss of deposits
Gap/Asset-Liability Mismatches
Return Risk
Rate of Islamic deposits < deposit interest rate
Rd < id
Rate of
Actual rate of return < indicated/expected rate of return
Implication of Negative Gap:
Example:
Profit = ($100m x 0.07) ($100 x 0.03)
= $7m - $3m = $4m
When market interest rates go up, what can happen to the
bank?
The bank cannot raise then profit rate to accommodate
prevailing cost of fund. If it does, the murabaha contract
turns invalid.
The bank will lose deposits when Islamic deposit rate (IDR)<
conventional interest rates (CII).
When it losses deposits and forced to acquire money market
funds at a higher cost, the bank earning drops. This is
known as the Displaced Commercial Risk (DCR).
To mitigate DCR, the Profit Equalization Reserve (PER) was
instituted.
PER serves to fill the gap between IDR and CII. Or the
expcted rate of return and the realized rate of return.
Liquidity Risk
Funding liquidity risk a banks inability to
mobilize deposits to satisfy withdrawals.
Also referring to deposit concentration risk.
Eg.
 LIQUIDITY RISK
Asset Deposit
Liquidity Liquidity
Risk Risk
Overdependence on
Unable to execute Corporate Deposits .
transactions at the
prevailing market price Overall cost of deposits
because there is no increases since
market appetite for the corporates always
product. demand higher rate of
deposits on GIA.

When an Islamic bank is overly

Inabiilty to dispose of dependent on corporate deposits,
the asset due to withdrawals due to maturities will
Shariah issues such as create severe asset-liability
prohibitions of bay al- mismatches. Cost overrun when the
dayn (sale of debt)at bank acquires funds from more costly
discount. money market sources such as
Negotiable Islamic instruments (NII).
Operational risk
Potential loss resulting from inadequate
systems, management failure, faulty
controls, fraud and human error.
Call for Board oversight to reduce
operational risk.
Legal risk
Legal risks becomes apparent when a
counterparty or an investor, losses money
on a transaction and decides to sue the
Islamic bank to avoid meeting its
obligation.
Case in Malaysia: Datok Nik Vs BIMB
In this way legal risk is synonymous with
shariah risk
Shariah Risk
Potential loss to the bank arising from cost
of litigations against the bank as result of
contract invalidation through the court of
law.
Shariah risk can be avoided by attending
to:
1.Financial reporting requirement
2.Legal documentation requirement
3.Maqasid-Shariah requirement.
Shariah risk in Islamic
Financial Instruments
Financial reporting: prior to PSA, bank must hold
ownership of asset. Recorded as fixed asset.
Legal documentation: transfer of ownership from bank to
customer. Warranties.
Maqasid approach: benefits outweigh the disbenefits.
Losses arising from money paid by Islamic bank to
customers when contracts were found invalid in favour
of customers.
Form over substance.
Contracts and legal documentation are not consistent.
Eg. Sale with no transfer of ownership title.
Sale without warranties
Purchase undertakings in Musharakah sukuk.
Shariah risk
Shariah risk is the potential loss to the
Islamic bank arising from cost of civil
actions carried or absorbed by the bank
from lawsuits by customers. The cost of the
civil actions may include:
Compensations and damages paid to
customers
Returning profit collected from the Islamic
facility
Cost of court proceedings
Reputation risk.
Shariah Risk
There are two aspects of financial
transaction involving Islamic banking
business, namely:
The concept of the transaction: This
concerns whether the contract is based on
sale, ijarah, wakalah, musharakah and
other common contracts in Islamic banking,
where the pillars of aqd are central.
The legal documentation of the transaction
that spelt out the rights, responsibilities
and obligations of the contracting parties.
In essence, it defines the relationship
between the bank and the customer.
Shariah Compliance: Consistency is
Critical to avoid Shariah risk

AQAD
Principles

LEGAL/CONTRACT
MAQASID DOCUMENTATION
Benefits vs disbenefits Protection of Rights

FINANCIAL
REPORTING
AAOIFI/IFSB/IFRS
Shariah Compliant
Parameters
Aqad-based Contract-based
Maqasid al-Shariah (purpose of the Law)
impact on society
Financial Reporting actual strength and
performance of companies
Legal documentation identification and
recognition of rights and obligations of
contracting parties.
Approved Islamic Finance
Products
BBA Home Financing
Bay Inah Home Financing
Bay Inah Personal
Financing/Overdraft/credit card
Tawaruk munazam personal financing
Commodity murabaha
Ijarah thumma al-bay
Bai-bithaman Ajil Islamic Debt
Securities (BAIDS)
Islamic
Discounted Bay al-dayn MuNif

Sukuk Ijarah
Sukuk Musharakah Bonds
Challenging issues in AQAD-based
Islamic Finance Products
Benchmaking profit rate against interest rate
(LIBOR,KLIBOR).
Profit Equalization Reserve (PER) displaced
commercial risk
Sale with condition to buyback at
predetermined price between two and three
parties.
Profit generated over installment payments
time value of money
Penalties on delayed payments
Benchmaking sukuk rates against LIBOR
Musharakah with Purchase undertakings
fixed profit to one party only.
Ijarah Sukuk - Sale with repurchase
agreement at par value and not mark-to
market
Ijarah Sukuk Ownership of asset by SPV
Profit-rate swaps speculation or gambling?
 #1 AQAD Method

Aqad

Agents Objectiv Ofer &

Subject
of e of Accepta
Matter
Contract Contract nce
 Sale (Al-
Bay)

Transfer of
Buyer & Ownership Price set on
Seller from Buyer Property the spot
to Seller
Contract of Sale
Example: Murabaha/BBA Sale

1. Buyer and Seller

eg. Seller owns asset/subject matter
before making sale
2. Subject matter
eg. Mal mutaqawim property with
usurfruct
3. Price
eg. Set on the spot
4. Ofer & Acceptance
eg. Verbal or in writing
Method #2: Maqasid al-Shariah/Objective of Shariah

To protect the interest of the public (society)-

maslahah al-ammah by:

1. removing the harm ( ibqa)

2. securing of benefits (tahsil)
#2 Maqasid Method
Maqasi
d
Sharia
h
Removi Securin
ng the g of
Harm Benefit
Objective of Shariah
Islamic financial products as defined by
AQAD methodology, should contain more
benefits (masalih) and less or no harm
(madarah).

in gambling (maisir) and liqour (qimar),

there are some sins and some profits. But
the sins are greater than the profits (Al-
Baqarah: 168).
 in Gambling (maisir) and Liqour (qimar),
there are some sins and some profits. But
the sins are greater than the profits (Al-
Baqarah: 168).

Mudarat Manfaat
Sins Profits

Gambling
& Liqour
 Muda Manfa
rat at

Riba
 Muda Manfa
rat at

Al-Bay
 Mudar Manfa
at? at?

Financing
BBA
 Mudar Manfa
at? at?

Plain
BBA
Mudarat >
Manfaat

HARAM
Mudarat <
Manfaat

HALAL
Downside (Madarrah) of Credit-
Financing

MACRO MICRO

Economic Bubbles Bankruptcy

Subprime Loans Foreclosure

Financial Turmoil Unemployment

The upside (Manfaat) of Credit-
Financing

MACRO MICRO

Allocation of Capital Wealth creation

Economic Growth Rich becoming richer

Leisure, luxury and

lifestyle
Maqasid
To analyse(theoretical) and
measure( empirical) impacts of financial
intermediation based on aqad-based
Shariah compliant products.
1. Efficiency studies
2. Profitability studies
3. Studies on Consumer welfare and
protection
4. Studies on Financial stability
Maqasid protecting public
interest.
Aqad-based products (ABP) SHOULD contain more
benefits and less harm.

What if, it was proven than they (ABP) contain more

harm than good?
eg. Abandon projects customer cannot make
recourse against bank as selling party?
Defaulted BBA customer are required to make
settlement based on the selling price.
Sale with no transfer of ownership.
Giving away clean inah personal financing at high
profit rates a way towards subprime inah?

Conflict between Aqad and Maqasid?

Method #3: Financial
Reporting
Proper recording of transactions to evident
TRUE SALE.
BBA bank must put BBA asset on balance
sheet prior to sale. I week, 1 month it
depends.
Once sold, it is recorded as BBA
receivables.
AITAB assets should be on banking book as
leasing assets but now treated as
financing and advances.
External auditors (PWC, KPMG etc.) are not
required by the authority to conduct
Shariah audit. And they may not be not
capable to do so.
Islamic Bank Average Balance
Sheet
Assets Liabilities

Murabaha/BBA Wadiah Dhamanah

deposits

AITAB Profit Sharing

Investment Acct

Islamic Securities/Sukuk Capital

 1st October 2008

Assets Liabilities

FIXED ASSET
1. BBA asset
15 October 2008
Assets Liabilities

CURRENT ASSET

2. BBA Receivables

1. 1/9/2008 Bank purchases Property from Vendor

for $200,000

2. 15/9/2008 Bank Sells Property to Customer for

$280,000
Do not Sell what you don not Own
Hadith (Sahih Bukhari)

High Court Judge Datuk Abdul Wahab Patail says that the
sale element in BBA sale is not a bona fide sale (Mayban Finance vs Taman Jaya)

BBA Legal Documentation

1. Sale and Purchase Agreement

(SPA)
2. Property Purchase Agreement
(PPA)
3. Property Sale Agreement (PSA)
4. Deeds of assignment/Charge
2. Bank do not have
legal + beneficial ownership
1. No transfer of title from Customer to Bank of property to make a valid sale
Method #4: Legal
Documentation
BBA should be documented as a true sale
and not as a loan. (Dato Nik vs. BIMB)

Ijarah should be documented as operating

lease and not a loan (Tinta Press vs. BIMB)
Islamic bank has not practice fairness
compared with conventional bank (Affin
bank vs Zulkifli).

Conflict between AQAD and documentation

of AQAD?
 Do not Sell what you don not Own
Hadith (Sahih Bukhari)

High Court Judge Datuk Abdul Wahab Patail says that the
sale element in BBA sale is not a bona fide sale

BBA Legal Documentation

1. Sale and Purchase Agreement

(SPA)
2. Property Purchase Agreement
(PPA)
3. Property Sale Agreement (PSA)
4. Deeds of assignment/Charge
2. Bank do not have
legal + beneficial ownership
1. No transfer of title from Customer to Bank of property to make a valid sale
Shariah Compliance: Consistency is
Critical

AQAD
Principles

LEGAL/CONTRACT
MAQASID DOCUMENTATION
Benefits vs disbenefits Protection of Rights

FINANCIAL
REPORTING
AAOIFI/IFSB/IFRS
Risk Measurement
Credit risk banking book
Credit scoring, Stress Testing, non-
performing financing (NPF)
Market risk trading book
VaR
Market risk banking book
Deposit-Asset mismatch,Gap, Duration
models
VaR: a measure for market risk
Market Risk:Trading Book
Value at Risk (VaR)
Bank purchases securities for both holding
and trading.
For holding, the securities are recorded in
the banking book. Potential loss in the
banking book is measured by Earning at
Risk (EAR)
For trading, the securities are recorded in
the trading book. Potential loss in the
trading book is measured by Value at Risk
(VaR)
Bond Trading
Bond Price = Coupon / interest rates
Price = $1000 per unit
i= 10%
Coupon = $100
$1000 = $100/0.1
An investors is deciding whether to purchase bond or not.
He will only buy bond in order to make capital gain. Thus, he
must buy low and sell high.
If he expects, interest rate to increase, he will not buy the
bond. This is because the bond price will fall and he losses out.
Example:
Buy at $1000. When interest rate increases to 20%, bond price
will fall; $500 = $100/0.2. He buys at $1000 per unit and now
the bond market value at $500. Loss = $500.
VaR what is the maximum loss the investor can absorb?
Bond Trading
Bond Price = Coupon / interest rates
Price = $1000 per unit
i= 10%
Coupon = $100
$1000 = $100/0.1
An investors is deciding whether to purchase bond or not.
He will only buy bond in order to make capital gain. Thus, he
must buy low and sell high.
If he expects interest rate to fall, he will buy the bond. This is
because he will make profit since the bond price now
increases. Example.
$1000 = $100/0.1. When interest rate indeed fall down, say
to 5%, bond price will increase to $2000. He will make a
capital gain of $1000.
$2000 = $100/0.05.
VaR
The senior management is told that
there is 1 in 100, say, chance of losing X
dollars over the holding period.
It means that there is a 1% chance that
the bank will lose $50 million over 1
year.
Var = $50m at 95% confidence interval
implies that there a 5% possibility that
the bank may lose $50m.
VaR
A VAR statistic has three components:
1. a time period,
2. a confidence level and
3. a loss amount (or loss percentage).

.Keep these three parts in mind as we give some examples

of variations of the question that VAR answers:

.What is the most I can - with a 95% or 99% level of

confidence - expect to lose in dollars over the next month?
.What is the maximum percentage I can - with 95% or 99%
confidence - expect to lose over the next year?
.You can see how the "VAR question" has three elements: a
relatively high level of confidence (typically either 95% or
99%), a time period (a day, a month or a year) and an
estimate of investment loss (expressed either in dollar or
percentage terms).
Value at Risk (VaR)
VaR is potential loss
VaR is the maximum loss at a preset confidence
interval
Confidence interval reflects the risk appetite of the bank
Confidence interval is also the probability that the loss
exceed capital of the bank, triggering bank insolvency.
Confidence interval is equivalent to the default
probability of the bank.
VaR shines for 3 main reasons:
1. it provides a complete view of portfolio risk
2. it is the basis of measuring economic capital
3. VaR assigns a dollar value to risk
VaR and Its Application
Senior management is told that there is 1 in 100, say,
chance of losing X dollars over the holding period.

There is a 1% chance that the bank will lose $50 million

over 1 year.

VaR= $50m at 99% confidence interval implies that

there a 1% possibility that the bank may lose $50m.

VaR is potential loss, thus when a VaR limit become

binding, it will put pressure on the banks trading
business to lower their risks.

For example, the trading book = $200 billion and the

VaR is $40 million. It means that there is 1% possibility
that the bank may lose $40m from the trading book
valued at $200 billion.
Usually, if the economy gets worse, VaR limit will be
 Estimating
VaR

The
Variance- Monte Carlo
historical
covariance simulation
simulation

Risk factors Risk factors

Risk factors
can be based on
as random
correlated past events
Stress Test: Serves to
complement VaR
VaR is used to provide a probabilistic prediction
on losses that are likely to happen for a pre-
specific holding period and confidence level.
It is difficult to ensure that by using Var,
extreme cases are fully covered.
The purpose of stress testing is to determine
the size of potential loss related to specific
scenarios or extreme cases.
The selection of scenarios is largely based on
expert judgment.
Stress testing show us how vulnerable a
portfolio might be to a variety of extreme
events.
Stress testing
ST is a standard risk management
technique used to identify and quantify
possible events of future changes in the
financial and economic conditions that
could have unfavourable efects on the
Banks exposure.
Conceptually, a ST is an approach to
revalue a portfolio using diferent set of
assumptions.
The objective is to better understand the
sensitivity of the portfolio to changes in
various risk factors.
This change is often expressed in terms of
 Actual Stress Stress Stress
Test Test Test
Baselin Plausibl Worse
e e

P&L
Capital $50b $48b $40b $35b
Base
RWA
RWCR 15% 13% 11% 9%
NPF 7% 8% 9% 11%
Stress Test

Worse Slow
case capita
High Low
risk l
NPL Profit
factor growt
s h
Risk-Factors
GDP
CPI
BLR
Unemployment rate
Retail Index
Property Index
Sensiti
vity
tests

Stre
ss
Test

Scenari
o tests
Sensitivity Tests
Instead of doing financial projection on a "best estimate"
basis, a company may do stress testing on capital, NPF
etc. where they look at how robust a financial instrument
is in certain crashes. They may test the instrument
under, for example, the following stresses:
What happens if the market crashes by more than x%
this year?
What happens if interest rates go up by at least y%?
What if half the instruments in the portfolio terminate
their contacts in the 5th year?
What happens if oil prices rise by 200%?
 Asses the
impact of large
movements in
financial Example
variables on 10% drop on the
Sensitivity test portfolio stock market
without indexes
specifying the
reasons for
such
movements
 Eg. Large US stock
Constructed in the market decline
light of historical 1987, Asian
Scenario
events or in the financial crises
Tests contexts of a 1997, Russion
specific portfolio default 1998,
September 11 2001
Stress Test : How can changes in economic
fundamentals afect banks capital?
Changes
in
interest
rates

Changes Extre Changes

in
commod
me in
Scenar exchang
ity
ios e rates
prices

Changes
in Equity
prices
Stress Test Credit Risk
The
Baselin
e case

Stress
Test
Credit
Risk
2% 1%
increas increas
e in e in
NPL NPL
 Adverse
macroecon Bank Credit
omic Failure Crunch
scenarios

Client Capital Recessi

Default Erosion on

Credit Bank Whats

Loss Loss Next?
Financial Stability: Bank Capital
Requirement
Basel II
Shariah Framework

Islamic
Banking

Bank Negara
Shariah Fiqh
AAOIFI
Supervisory Academy
Board
Regulatory Framework

Islamic
banking

Islamic
Financial
Basel II
Service
Board
 Basel II

Minimum
Supervisory Market
Capital
Review Discipline
Requirement

1. Standardized
Based
Approach
2. Internal
Based Rating
Approach
Basel II
The objective of Basel II is to protect depositors fund through an
international standard concerning how much capital banks need to put
aside to guard against losses arising from exposures to risks. This is
done by establishing rigorous risk and capital management
requirements designed to see that the bank holds sufficient capital
reserves appropriate to the risk it is carrying through its lending and
investment practices. Hence, the more the bank is exposed to risk, the
greater is the amount of capital the bank needed to back up the assets.
The three pillars if Basel II is shown in the following diagram:

3 Pillars of Basel II
Minimum capital Requirement
Supervisory Review
Market Discipline
 Thus, bank must hold sufficient
capital as a back up to the amount
of money they owe depositors
Loss due to default afects Banks
capital
Insufficient banks capital leads to
bank runs and foreclosure financial
instability.
The objective of Basel is to protect
the depositors since deposits
mobilization is based on creditor-
debtor contract. Basel II
 Risk-
Risk weight assets are the sum of Weights
asset subject to market, credit
and operational risk.
Total
CAR = Total Capital / (Credit risk Capital
+ Market risk + Operational Risk)
Ratio
Capital Adequacy Ratio
(minimum = 8%)
Basel II
Pillar 1: Capital Requirement
The first pillar deals with maintenance of regulatory capital calculated for three
major components of risk that a bank faces:
1. credit risk potential loss arising from non-performing loans and bad debts
2.operational risk potential loss arising from system and human error in running
banking operation
3. market risk. potential loss caused by market volatilities that may erode value of
investment in securities.
4. The credit risk component can be calculated in three diferent ways of varying
degree of sophistication, namely:

A) Standardized Approach: The risk-weights are based on available external credit

ratings, say set by the regulatory authority or rating agencies.
B)Foundation Internal Rating-Based Approach (IRB): The risk-weights set
by the bank (i.e PD) and LGPD set by the regulators.
C) Advanced Internal Rating-Based Approach (IRB)
For operational risk, there are three diferent approaches -
basic indicator approach or BIA, standardized approach or TSA, and
advanced measurement approach or AMA.
For market risk the preferred approach is VaR (value at risk).
Capital Requirement
The capital requirement is a bank regulation, which sets a
framework on how banks and depository institutions must handle their
capital.
The categorization of assets and capital is highly standardized so that it
can be risk weighted. Internationally, the
Basel Committee on Banking Supervision housed at the
Bank for International Settlements influence each country's banking
capital requirements. In 1988, the Committee decided to introduce a
capital measurement system commonly referred to as the
Basel Capital Accords (Basel Accord).
This framework is now being replaced by a new and significantly more
complex capital adequacy framework commonly known as Basel II.
While Basel II significantly alters the calculation of the risk weights, it
leaves alone the calculation of the capital. The capital ratio is the
percentage of a bank's capital to its risk-weighted assets.
Weights are defined by risk-sensitivity ratios whose calculation is

dictated under the relevant Accord .

Determination of Capital Requirement in Basel II

Commercial
Banks

Standardized
Internal Rating
Rating Based
Based Banks
Banks

Risk weights sets

by regulators Risk-weights
and external sets by Bank and
credit rating Regulator
agencies
Capital Requirement
Tier 1 capital is the core measure of a
bank's financial strength from a regulator's
point of view. It consists primarily of 1)
shareholders' equity but may also include
preferred stock that is irredeemable and
non-cumulative and 2) retained earnings.
Pillar 2 : Supervisory Review
The second pillar deals with the regulatory
response to the first pillar, giving regulators
much improved 'tools' over those available
to them under Basel I. It also provides a
framework for dealing with all the other
risks a bank may face, such as
systemic risk, pension risk,
concentration risk, strategic risk,
reputation risk, liquidity risk and legal risk,
which the accord combines under the title
of residual risk.It gives bank a power to
review their risk management system.
Pillar 3: Market Discipline
The third pillar greatly increases the
disclosures that the bank must make
through regular financial reporting to the
bank supervisors. This is designed to allow
the market to have a better picture of the
overall risk position of the bank and to
allow the counterparties of the bank to
price and deal appropriately.

Impact of Basel II on Islamic

Banking Capital Requirement
Uneven Playing Field
 Standardized Approach:
Conventional Bank
Assets Amount Riskweights
RWassets
Loans $600m 50% $300
Hire-Purchase$300m 50% $150
Personal Loans $200m 100% $200
Bond $100m 50% $ 50
TOTAL $1200 $700

Capital ratio = (Regulated Capital / RWA)

8% = RC / $700
RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100
x 0.5)]
= $300m + $150m +$200m + $50m = $700

RC = $700 x 0.08 = $56m

Note Risk weight also known as conversion factor.
Risk-weights set by external rating institutions and regulators.
 Standardized Approach:
Conventional Bank : Exercise 1
Assets Amount Riskweights
RWassets
Loans $ 1200m 50% $
Hire-Purchase$600m 50% $
Personal Loans $300m 100% $
Bond $200m 50% $
TOTAL $1200 $

Capital ratio = (Regulated Capital / RWA)

8% = RC / $700
RWA = [($1200m x 0.5) + ($600m x 0.5) + ($300m x 1.00) +
($200 x 0.5)]
=$

RC =
Note Risk weight also known as conversion factor.
Risk-weights set by external rating institutions and regulators.
 Islamic Bank Under Basel 2: Higher
Capital Requirement
Assets Amount Riskweights
RWassets
Murabaha $600m 50% $300
AITAB $300m 50% $150
Personal F$200m 100% $200
Sukuk $100m 50% $ 50
TOTAL $1200 $700

Capital ratio = (Regulated Capital / RWA)

8% = RC / $700
RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100
x 0.5)]
= $300m + $150m +$200m + $50m = $700

RC = $700 x 0.08 = $56m

Note Risk weight also known as conversion factor.
 Islamic Bank with Musharakah financing
under Basel 2: Higher Capital
Requirement
Assets Amount Riskweights
RWassets
Murabaha $500m 50% $250
AITAB $300m 50% $150
Personal F$200m 100% $200
Sukuk $100m 50% $ 50
Musharakah $100m 250%
$250
TOTAL $1200 $900

Capital ratio = (Regulated Capital / RWA)

8% = RC / $900
RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100
x 0.5) + ($100 x 2.5)]
= $250m + $150m +$200m + $70m + $250 = $900

RC = $900 x 0.08 = $72.00m

Note Risk weight also known as conversion factor.
Stress on Islamic bank capital
Since the risk-weight for Musharakah is 250%,
the bank is charged higher capital from $56m
to $78m. The bank has to come up with $22m
more capital to meet regulators requirement in
order to undertake the Musharakah project.
In this sense, the Musharakah project places
stress of Islamic bank capital.
Basel II assumes that Islamic deposits are
similar with conventional deposits.
In conventional deposits, the deposits and
interest income are guaranteed.
This is not the case for Islamic deposits since
they are based on profit-sharing system. In this
manner, the bank need not provide capital
Bank Negara Malaysia (BNM) Guidelines on Profit-Sharing
Investment Account (PSIA) with risk absorbent
In order to highlight the more accurate nature of mudarabah
deposits (PSIA) and its impact on bank capital, BNM has
provided a new formulation for determining regulated for
Islamic banks.
PSIA will be used to finance a relatively more risky projects
based on mudarabah, istisna and musharakah contracts.
The formulation capital adequacy ratio (CAR) = Capital/ (RWA
less (1-)RWA funded by PSIA less ()RWA in the form of PER)
When = 1, the bank holds all risks in the balance sheet.
When is say 30%, the bank carry risks only from wadiah
dhamanah deposits and general mudarabah deposits.
Then 70% of the risks (1-) = (1-0.3), is carried by PSIA
deposits.
Then CAR will be less than CAR without as a risk-absorbent
factor. This will reduce stress on Islamic banking capital.
Hence, the smaller the i.e. the more risks carried by PSIA, the
lower is the CAR.
Modified Formula Incorporating the
Risk nature of Mudarabah Deposits
RWCAR = [Capital Base] /[(TRWAIslamic)
Islamic

Less
(1-) (Credit and Market Risk
Weighted Asset funded by PSIA)
Less
()(proportional of Credit and
Market Risk Weighted Assets funded by
PSIA in the form of PER)]
 Islamic Bank with Musharakah financing
under Basel 2: Higher Capital
Requirement
Assets Amount Riskweights
RWassets
Murabaha $500m 50% $250
AITAB $300m 50% $150
Personal F$200m 100% $200
Sukuk $100m 50% $ 50
Musharakah $100m 250%
$250
TOTAL $1200 $900

Capital ratio = (Regulated Capital /( RWA [1-]RWA funded by PSIA [] RWA funded by PSIA
as PER)
1.= 30%
2.(1-) = 70%
3.RWA funded by PSIA = $250m (musharaka)
4.RWA as PER = $2m (by assumption)
RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5) + ($100 x
2.5)]
= [$250m + $150m +$200m + $70m + $250] - (0.7)($250) (0.3)($2) = $900m -
$175m - $0.6m = $724.4m

RC = $724.4 x 0.08 = $57.95m

(1-) represents the quantum of PSIA
recognized as a risk absorbent for RWCR
computation purposes and approved by
Bank Negara Malaysia.
= 1 means all risks carried by bank
= 0 means all risks carried by PSIA.
The smaller the , the lower is RWCR.
 Corporate Governance and Risk
Management:
Basel II Pillar 3 on Market Discipline

Scandals and failure of energy giant

Enron, WoldCom and Global Crossing
and now the Subprime Banking
crises in the USA that saw the fall of
giant Lehman,Morgan Stanley,AIG
etc.
Basel II Pillar 3
Aims at strengthening market discipline, i.e
the pressure that financial markets may
exert on bank managers so as to promote
safe and sound bank management.
Pillar 3 defines a number of disclosures
requirements aimed at increasing the
transparency of each banks risk profile and
risk policy.
Corporate Governance
Boards were provided with misleading
information
Breakdown in the process by which
information was transmitted to the board
and shareholders.
Breakdown involving financial engineering
and nondisclosure of economic risks
Outright fraud.
Regulatory authorities must upgrade work
to protect all stakeholders.
Legislations to mend perceived failures in
corporate governance practices.
Board and Corporate
Governance
The primary responsibility of the board is to
ensure that it develops a clear
understanding of the banks business
strategy and the fundamental risks and
rewards it implies.
The board must make sure that risks are
transparent to managers and to
stakeholders through adequate internal and
external disclosure
The board must characterize an
appropriate risk-appetite for the firm.
Business Strategy, Board and Risk
Management
1. Avoid risk by choosing not to undertake some
activities.
2. Transfer risk to third parties through insurance,
hedging and outsourcing, subject to Shariah rules.
3. Mitigate risk such as operational risk, through
preventive and detective control measures.
4. Accept risk, recognizing that undertaking certain risky
activities should generate shareholder value.
. Board should ensure that business and risk management
strategies are directed at economic rather than accounting
performance.
. Board must make sure that the bank has put in place an
efective risk management program that is consistent with
these fundamental strategic and risk appetite choices.
. It must make sure that there are efective procedures in
place for identifying, assessing and managing all types of
risk ie. business risk, operational risk, market risk, liquidity
Basel II and IFSB
High risk-weights for Musharakah Financing
to imply that bank bears business risk and
the general investment account holders
(GIA) do not.
Recent PSIA guidelines will test risk
appetite of depositors.
Limits and Limits Standard
Policies.
Market-risk limits serve to control the risk that
arises from changes in the absolute price (or
rate) of an asset.
Credit risk limits serve to control and limit the
number of defaults as well as limiting a
downward migration in the quality of the credit
portfolio.
It is best practice for institutions to set down on
paper the process by which they establish risk
limits, review risk exposures, and approve limit
exceptions and to develop an analytical
methodology used to calculate the banks risk
exposures.
For many banks, best practice risk governance
MIC FINANCIAL SERVICES BOARD (IFSB)

B2002 Risk Management for

Financial Institutions

C FINANCIAL SERVICES BOARD (IFSB)

ARDS
MIC FINANCIAL SERVICES BOARD (IFSB)

G PRINCIPLES OF RISK MANAGEMENT

STITUTIONS
THAN INSURANCE INSTITUTIONS)
NG ONLY ISLAMIC FINANCIAL SERVICES (IIFS)
ber 2005
IFSBS GUIDING PRINCIPLES OF RISK
MANAGEMENT

1. GENERAL REQUIREMENT
Principle 1.0 : IIFS shall have in place a comprehensive risk
management and reporting process, including

i) appropriate board and senior management oversight,

ii) to identify, measure, monitor, report and control

relevant categories of risks and, where

iii) appropriate steps to comply with Shariah rules and

principles and

iv) to ensure the adequacy of relevant risk reporting to the

supervisory authority.
IFSBS GUIDING PRINCIPLES OF RISK
MANAGEMENT

2. CREDIT RISK
Principle 2.1 : IIFS shall have in place a strategy for
financing, using various instruments in compliance
with Shariah, whereby it recognises the potential
credit exposure that may arise at diferent stages
of the various financing agreements.
IFSB GP RISK MANAGEMENT
CREDIT RISK

Principle 2.2 :

IIFS shall carry out a due diligence review in

respect of counterparties prior to deciding on
the choice of an appropriate Islamic financing
instrument.
IFSB Credit Risk
Principle 2.3

IIFS shall have in place appropriate

methodologies for measuring and
reporting the credit risk exposure arising
under each Islamic financing instrument.
IFSB Credit Risk
Principle 2.4

IIFS shall have in place Shariah compliant

credit risk mitigating techniques
appropriate for each Islamic financing
instrument.
IFSBS CAPITAL ADEQUACY STANDARDS

CAPITAL ADEQUACY STANDARDS

(CAS)
IFSBS CAPITAL ADEQUACY STANDARDS
(CAS)

KEY OBJECTIVES OF CAS

Sets out a common structure for the assessment of Islamic Institutions Offering
Financial Services (IIFS) capital adequacy requirements, which will support
transparency and consistent methodology for all IIFS.

A common approach without compromising Shariah rules and principles by

substantially enhancing the transparency of true obligations within IIFS
operations.

Promotes a level playing field at a global level as far as common assessment is

concerned especially for the minimum capital requirements in respect of both
credit and market risks arising from each financing mode at different stages of a
contract.

Recognition of investment account holders account holders (IAH) as partners in

IIFS operations should result in a more effective use of capital.
IFSBS CAPITAL ADEQUACY STANDARDS

To ensure that Islamic banks can absorb a reasonable level

of losses before becoming insolvent.

To provide protection to depositors and/ or PSIA the higher

the CAR, the higher the level of protection.

To promote stability and efficiency of the financial system by

reducing the likelihood of Islamic banks become insolvent.

To ensure that the Islamic banks capital position

commensurate with its overall risk profile and strategy.
IFSBS CAPITAL ADEQUACY STANDARDS

GENERAL PRINCIPLES OF CAS

IIFS are required to use the substance of the Shariah rules and
principles governing the contracts to form the basis for an
appropriate treatment in deriving their minimum capital
adequacy requirements.

Capital adequacy requirements vary according to the

transformation of risks at diferent contract stages.
IFSBS CAPITAL ADEQUACY STANDARDS

GENERAL PRINCIPLES OF CAS

On basis of either Mudarabah or Wakalah contract, credit and market
risks of the investment made by the IAH shall normally be borne by
themselves, while the operational risk is borne solely by the IIFS
(unless proven negligence, mismanagement or fraud).
IFSBS CAPITAL ADEQUACY STANDARDS

Credit risk is measured according to the Standardised Approach of Basel

II, except for certain exposures arising from investments by means of
Musharakah or Mudarabah contracts in assets that are not held for
trading.

Until adequate historical data are available, the IFSB employs Basels
risk weights.
IFSBS CAPITAL ADEQUACY STANDARDS

MARKET RISK
Apart from market risk exposures arising from equity, foreign

exchange, commodities, the exposures also include trading positions

in sukuk and inventory risk, which results from IIFS holding assets

with a view to re selling or leasing them.

In the case of equity investment made by means of Musharakah or

Mudarabah contract where the underlying assets are commodities

held for trading, market risk provisions for commodities are

applicable.

For inventory risk, only simplified approach is applicable.

IFSBS CAPITAL ADEQUACY STANDARDS

OPERATIONAL RISKS

Shariah noncompliance risk is a type of operational risk facing

the IIFS which can lead to non recognition income and resultant
losses.

The extent of losses from non compliance with Shariah rules

and principles cannot be ascertained owing to lack of data.
Supervisory authorities have discretion to impose a RW

higher than 15% as they deem fit to cater for the Shariah
noncompliance risk of a particular IIFS.
IFSBS GUIDING PRINCIPLES ON
CORPORATE GOVERNANCE

GUIDING PRINCIPLES ON CORPORATE GOVERNANCE FOR

INSTITUTIONS OFFERING ONLY ISLAMIC FINANCIAL SERVICES
(EXCLUDING ISLAMIC INSURANCE (TAKAFUL) INSTITUTIONS
(IIFS)
AND ISLAMIC MUTUAL FUNDS)
IFSBS GUIDING PRINCIPLES ON
CORPORATE GOVERNANCE

GENERAL GOVERNANCE APPROACH

PART 1
Principle 1.1 :IIFS shall establish a
comprehensive governance
policy framework which sets out
the strategic roles and functions
of each organ of governance and
mechanisms for balancing the
IIFSs accountabilities to various
stakeholders.
IFSB Guiding Principles on Corporate Governance

Principle 1.2

IIFS shall ensure that the reporting of their

financial and non-financial information meets
the requirements of internationally
recognised accounting standards which are
in compliance with Shariah rules and
principles and are applicable to the Islamic
financial services industry as recognised by
the supervisory authorities of the country.
IFSBS GUIDING PRINCIPLES ON
CORPORATE GOVERNANCE

PART 2: RIGHTS OF INVESTMENT ACCOUNT

HOLDERS
Principle 2.1 : IIFS shall acknowledge
IAHs right to monitor the
performance of their
investments and the associated
risks, and put into place
adequate means to ensure that
these rights are observed and
exercised.
IFSBS GUIDING PRINCIPLES ON
CORPORATE GOVERNANCE

PART 2: RIGHTS OF INVESTMENT ACCOUNT

HOLDERS
Principle 2.2 : IIFS shall adopt a sound investment
strategy which is appropriately aligned
to the risk and return expectations of
IAH (bearing in mind the distinction
between restricted and unrestricted
IAH, and be transparent in smoothing
any returns.
IFSBS GUIDING PRINCIPLES ON
CORPORATE GOVERNANCE

PART 3: COMPLIANCE WITH SHRAIAH

RULES AND PRINCIPLES
Principle 3.1 :IIFS shall have in place an
appropriate mechanism for obtaining
rulings from Shariah scholars, applying
fatawa and monitoring Shariah
compliance in all aspects of their
products, operations and activities.
IFSBS GUIDING PRINCIPLES ON
CORPORATE GOVERNANCE

PART 3: COMPLIANCE WITH SHRAIAH

RULES AND PRINCIPLES

Principle 3.2 : IIFS shall comply with the Shariah rules and
principles as expressed in the rulings of the
IIFSs Shariah scholars. The IIFS shall make
these rulings available to the public
 IFSBS GUIDING PRINCIPLES ON
CORPORATE GOVERNANCE

Part 4 : Transparency of Financial Reporting

in respectof Investment Accounts

Principle 4 : IIFS shall make adequate and timely

disclosure to IAH and the public of material
and relevant information on the investment
accounts that they manage.
Thank You

Best wishes on your examination