TK 6413 / TK 5413 : ISLAMIC RISK MANAGEMENT

TK 6413 / TK 5413 : ISLAMIC RISK MANAGEMENT TOPIC 2: THE IDENTIFICATION OF RISK EXPOSURES

(I) INTRODUCTION • Usually the process of identifying the risks facing an organization is a two-party activity i.e., an internal personnel and an external risk specialist or consultant; • Risk identification techniques have been developed simultaneously by professionals from different disciplines such as: • Production engineers; • Accountants; • Quantity surveyors; • Marketing managers; • Each group has been concerned and exposed to a somewhat different problem, the strategies and techniques adopted therefore for identifying the risks and hazards have also differed;

Risk identification by definition is the process by which an organization is able to learn of the areas in which it is exposed to risk; identification techniques are designed to develop information on sources of risk, hazards, risk factors, perils and exposure to loss; • The task of risk identification evolves continuously; changes in the organization and the environment require constant attention to the identification of new risks; the organization itself changes through means such as entry into new lines of business, withdrawal from others, acquisition and divestiture; in addition, the environment changes, as exemplified by evolving legal responsibilities, changes in government mandates and administrative rules, and changing rules of good citizenship;

Sources of Risk: • The following are sources of risk according to the different environment set up, • Physical environment; • Social environment; • Legal environment; • Operational environment; • Economic environment; • Cognitive environment; • Identification of Exposures: • Sources of risk are essentially of no concern to an organization unless that organization is exposed or vulnerable to the perils that arise from those environments; therefore, an important aspect of risk identification; four categories of risk exposure are:

Physical Asset Exposures; • Financial Asset Exposures; • Liability Exposures; • Human Asset Exposures; • Checklist Used in Risk Identification: • A risk manager interested in identifying potential profit opportunity will have to develop a framework in the form of a risk checklist; • If a fairly comprehensive checklist can be developed, the next step is the creation of a systematic approach to discover which of the potential losses and gains included in the framework are faced by the organization; implicit in this second step is the development of an identification system that will enable the risk manager to receive information about risks on an ongoing basis;

Types of checklist: • Traditionally the risk assessment checklist have offered a framework for identification of insurable risks; • Such checklists are useful starting points for the development of an overall analytical framework, but there are two important limitations: (i) standardized checklists will fail to list risks that are unusual or unique to a particular organization; (ii) since traditional risk management has not been concerned with speculative risks, the checklist is unlikely to acknowledge this type of risk; • Applying a checklist: • One method of applying the checklist is to focus on possible sources of risks; the seven sources of risk outlined earlier provide a good starting point;

A similar approach advocated by John O’Connell identifies four components of the relevant environment: (i) customers; (ii) suppliers; (iii) competitors; and (iv) regulators; • Supplemental Techniques: • Regardless of the method used to apply the checklist, at least nine techniques • are available to supplement the analysis; these methods include: • the financial statement method; • the flow-chart method; • on-site inspections; • planned interactions with other departments; • interactions with outside suppliers and professional organizations; • contract analysis; • statistical analysis of loss records; • incident reports; • hazard analysis;

Risk Management Information Systems: • To identify new risks, the risk manager needs a far-reaching information system, which yields current information on new developments that may give rise to risk; in addition, the risk manager needs a system of maintaining the wide range of information that affects the organization’s risk; • With the overall system, are subsytems such as: • Risk Management Policy Manual: • Depositing of all risk management corporate policies; • Claim reporting requirements; • Usage of companys’ assets; • Risk Management Record Systems: • Property valuation schedules • Vehicle and mobile equipment schedules

Request for insurance bids and coverages • Insurance registers • Claim reports • Loss data • Premium and loss comparison • Risk Management Systems: • Risk information management system database • Support risk management decision process • Consolidation of various form of data • Cost of risk management administration • Internal Communication System: • Information channels • Introduction of new products • Acquisition of new locations • Progress on claims • Information on hiring activities

(II) OVERVIEW OF FINANCIAL RISKS • Since all the financial entities are directly or indirectly interwoven, interlinked, and interrelated, they create a complicated maze of uncertainties which makes up the mass of the financial risk; • At the level of the enterprise, the risks can be grouped into financial, business and operational risks; financial risks will generally include credit, market and liquidity risk; business risk is a combination of management and strategic risk; the operational risk can arise due to people, processes, systems, as well as several other factors.

(a) Credit Risk: • Credit risk is simply defined as the potential that a borrower or counterparty will fail to meet its obligation in accordance with agreed terms. This arises from the inability of the counterparty to service the debt on the terms agreed upon. It can also arise when the solvency or the credit rating of the counterparty changes adversely. • Credit risk cannot be accurately calculated before the event since the likelihood of default is highly uncertain and this is difficult to predict accurately. Although there are developments in the calculation of credit risks, the major difficulty remains with the availability of data.

Relations between the Islamic counterparties and contracts and the guaranties and collaterals are as follows : Risk Coverage Risk Coverage Agreement

In the structure of the Islamic financial products, counterparties are all the parties that are involved in the Islamic contract agreements and partnership. Thus, • In Murabaha and Salam contracts – alongside the banks, both the seller and buyer are considered as counterparties; • In Ijarah contracts – the renter/lessees; • In Istisna’a contracts – the buyer, user contractor or manufacturer • In musharakah & mudarabah contracts – the business partners and agents; • Financial institutions that provide Islamic financial products are also exposed to credit risk because of the emphasis on lending in the Murabaha, leasing in the Ijarah, promising to deliver or to buy in Istisna and Salam, and investing on business performance in the Musharakah and Mudarabah contracts.

Islamic Financial Contracts Market Risk Coverage Counter parties Counter party B Risk Coverage Murabaha Guarantee A Collateral A 100% Guaranty B 25 % 100 % Counter party C Counter party A 5 % Istisna Collateral B 72 % 8 % 18% 30 % 5 % Collateral C Musharakah Counter party D 42 % Collateral D Strategies 95 % Representation of the links between a counterparty with several contracts and risk coverage by several guaranties and collaterals

From the above counterparty analysis the following points should be considered: • The market conditions and the institutions strategies that may influence the counterplay’sbehaviour; • The type and the volume of the contracts where the counterplay is linked, defining also the degree of participation; • The links between the contracts that refer to the some counterparty; • The rates at the guaranties and collaterals and their inter-links, s well as the links to the contracts and counterparties. Note that the counterparties must be covered by guaranties and collaterals that are rated with a higher grade.

Looking from the aspects of the various Islamic financial contracts, the Islamic financial services (IIFS) is exposed to the following credit risks: • Murabahah: The IIFS is exposed to credit risk following the exchange of the products between IIFS and a customer. It is a settlement risk/default risk whereby the customer may not be able to honor the payment obligation (loss of receivables).

(2) Salam: The IIFS is exposed to the settlement/delivery risk where goods are not delivered, or not delivered on time, or not according to specification by the seller/customer after payment is made (loss of invested amount). Another scenario is that the IIFS may not be able to recover its capital from Salam customers fully; or claims against urboun or a financial guarantee are not sufficient to cover the whole amount of salam capital. (3) Istisna: The IIFS may risk facing the customer who is unable to honor the payment obligation for deferred installments or progress billings (loss of amount receivables) when the work is already in progress.

Istisna’a with parallel istisna’a: • The IIFS may be exposed to completion risk in the parallel istisna’a, when an advance payment has been made by the IIFS and the sub-contractor does not complete the work. The situation is greatly aggravated if no other sub-contractor is available as a replacement. Such a situation leads to risks in the direct istisna’a according to which the IIFS has an obligation to the ultimate customer. In addition, payments made by the IIFS to the sub-contractor may not be recoverable. • 5. Operating Ijarah and IjarahMuntahiaBittamleek (IMB): • The customer (lessee) may be unable to service the lease rental as and when it falls due, and thus defaults on this obligation. In principle, the IIFS as lessor has the right to repossess the leased asset if the lessee defaults, thus mitigating the credit risk. However, particularly in the case of IMB, there may be difficulties in exercising this right.

6. Musharakah: • The IIFS is exposed to the risk of losing its entire invested capital in musharakah financing or investment, since such capital may not be recovered as it ranks lower than debt instruments upon liquidation. In different situation, an IIFS may face a risk when a withdrawing partner owes monies to the IIFS (loss of invested capital). • 7. Mudarabah: • The IIFS is exposed to capital impairment risk if the venture being financed incurs losses, or if the mudarib defaults on payments due to the mudarib.

(b) Market Risk: • Market risk is the of losses in on-and-off balance sheet positions arising from movements in market prices, interest rates, FX rates and equity values where these are the main four market risk factors.

The four types of market risks that exist in the different Islamic financial products are : Market Risk Rate of Return Risk Commodity Risk FX rate risk Equity Risk Murabaha Murabaha Murabaha Mudarabah Ijarah Ijarah Salam Musharakah Salam Salam Istisna’a Istisna’a Istisna’a Mudarabah Musharakah

The IIFS are exposed to market risk in a unique manner. The Shariah principles, to which these institutions adhere, include the notions of materiality in transactions and the sharing of risks and rewards. As a result, IIFS carry out many asset-based transactions in which they take ownership of physical assets as co-investors. This setting exposes them to market risk-as the asset price may fluctuate.

In an IIFS, market risk exposures result from: (1).Non-binding Murabahah for the purchase order (MPO): • If the customer cancels the agreement to purchase (AP), the IIFS has to sell the goods in the open market at a selling price that can be lower than the purchase price. The IIFS may have to devote resources to marketing efforts in order to sell the cancelled purchase goods, or have to dispose of the asset at a loss. Alternatively, IIFS may have to hold the goods and incur additional costs, such as warehousing, insurance or even damages (if goods are perishable).

(2) Salam: • Since salam is a forward purchase of goods, upon signng the contract, the IIFS is exposed to price risk on the goods, i.e. the spot price on delivery may be lower than the amount paid. • (3) Salam with parallel salam: • If the supplier under the saam defaults on delivery, the IIFS may have to purchase the goods in the open market in order to meet its delivery obligation under parallel salam. Apart from the credit risk, the IIFS is also exposed to price risk, as the open market price that has to be paid may exceed the amount paid under the slam contract.

4. Istisna’a with parallel istisna’a: • If the customer under a direct istisna’a defaults on the contract and the IIFS has to find another purchaser for the asset, it is exposed to a price risk-namely, that a purchaser can be found only for a price lower than the original contract price. In principle, any such loss should be recoverable from the defaulting customer, but such recovery may be problematic.

(5) Operating Ijarah and IjarahMuntahiaBittamleek (IMB): • When the customer opts not to fulfill a non-binding agreement to lease, and the IIFS has already acquired the asset, it may have to lease (or sell) the asset at a lease rental (or selling price) lower than the originally agreed total rentals (or selling price) to the original customer. This represents another form of price risk. • (6) Operating Ijarah: • The IIFS will bear the potential loss due to the fair value of the asset failing below its residual value as estimated at lease inception (residual value risk).

(c) Operational Risk: • Operational risk is defined in Basel II as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events including legal risk but excluding strategic and reputational risk. • The three major components of operational risk therefore are people, processes, technology, or some other external events. People’s risk include human errors, lack of expertise, compliance and fraud. Process risks include risks related to different aspects of running a business, which may include regular business processes, risks related to new products and services, inadequate/insufficient control, etc. Failures related to systems are included in technology risks.

In the context of the Islamic financial services industry, appropriate systems, processes and products are all recent developments. Continued growth in the industry poses a continual challenge in these areas of development, and failures in managing these areas will bring negative consequences. • In the case of Islamic banks, operational risks faced can be divided into three categories: (1) Operational risk that are consequential upon various kinds of banking activities, and which are somewhat similar for all financial intermediaries, whether shariah-compliant or not. However, the asset-based nature of financing products in Islamic banking such as murabahah, salam, istisna’a and ijarah may give rise to forms of operational risk in contract drafting and execution that specific to such products.

(2) Shariah compliance risk – that is (i) risks relating to potential non-compliance with shariah rules and principles in the bank’s operations; and (ii) he further risk associates with the Islamic bank’s fiduciary responsibilities as mudarib toward fund providers under the mudarabah form of contract, according to which in case of misconduct or negligence by the mudarib the funds invested by the fund providers become a liability of the • mudarib. Shariah compliance risk is the risk of non-compliance resulting from a failure of an Islamic bank’s internal systems and personnel that should ensure its compliance with shariah rules and principles determined by its shariah board or the relevant body in the jurisdiction in which the Islamic bank operates. • (3) Legal risks arising either from: (i) the Islamic bank’s operations (legal risk common to all financial intermediaries); or (ii) problems of legal uncertainty in interpreting and enforcing shariah contracts.

The following are unique operational risks of Islamic Financing/Investment Modes: • (i) Murabahah: • It is one of the most predominantly used contracts in Islamic • finance. Apart from credit risk exposures, there are two types of • operational risk relating to the structure of a murabahah contract: • (1)The different viewpoints of murabahah permissibility can be a source of operational risk. For example, IT systems employed across jusrisdictions may have to be designed to meet the requirements of certain jurisdictions. • (2)At the contract signing stage, since the contract requires the Islamic bank to purchase the asset first before selling to the customer, the bank needs to ensure that the legal implications of the contract properly match the commercial intent of the transactions.

(3) In addition, problems may arise if the murabahah customer acts as the Islamic bank’s agent in the purchase of the asset that is subject-matter of the contract. For the murabahah to be valid, title to the asset must pass first to the bank and not directly to the customer. The documentation, including letters of credit, must be drawn up so as to ensure this. • (ii) Salam and Parallel Salam • Salam is a type of forward contract with immediate payment where an • Islamic bank assumes the role of the forward purchaser of a • commodity. In assuming the role of the purchaser, the bank exposes • itself to the following operational risks: • (1) the bank has to accept the goods that are the subject-matter of the contract even though they are delivered early, should the specifications be met. The bank may have to incur additional costs such as warehousing, insurance, or even damage (for perishables) in the event that it cannot sell the goods promptly following delivery.

Salam is generally associated with the agricultural sector. The buyer must either reject goods of an inferior quality to that specified in the contract, or accept them at the original price. In the latter case, the goods would have to be sold at a discount (unless the customer under a parallel salam agreed to accept the goods promptly following delivery). (3) For salam with parallel salam, the IIFS may face legal risk if the goods cannot be delivered at the specified time (unless the customer under parallel salam agrees to modify the delivery date).

(iii) Istisna’a and Parallel Istisna’a: • In this form of contract, risks may include the following: • The Islamic bank may be unable to deliver the asset on time, owing • to time overruns by the sub-contractor under the parallel istisna’a and may thus face penalties for late completion. • Cost overruns under the parallel istisna’a contract may, unless agreed with the customer under the istisna’a contract, have to be absorbed partly or wholly by the Islamic bank. • (3) The subcontractor may fail to meet quality standards or other • requirements of the specification, as agreed with the customer under the istisna’a contract. The IIFS may face legal risk if no agreement is reached with subcontractor and the customer either for remedying the defects or for reducing the contract price. • If the subcontractor turns out to be unable to complete the work, • the bank will need to find a replacement. In certain cases, this may be very difficult and costly.

(iv) Ijarah and IjarahMuntahiaBittamleek (IMB): • In simple terms, an ijarah contract is an operating lease, whereas IMB is a lease–to-purchase. While operational risk exposures during the purchase and holding of the assets may be similar to those in the case of murabahah, other operational risk aspects include the following: • The Islamic bank needs to ensure that the asset will be used in a shariah-compliant manner. Otherwise, it is exposed to non-recognition of the lease income as non-permissable and the need to reposes the asset and find a new lessee. • If the lessee damages the assets in its possesion, the islamic bank may face refusal by the lessee to make the damage good. In such a case, the bank needs to be able to reposes the asset and to take legal action against the lessee to recover damages.

(3) If the leased asset is severely damaged or destroyed through no fault of the lessee, the Islamic bank as a lessor is required to provide an alternative asset, failing which the lessee can terminate the lease without paying rentals for the remaining duration of the contract. Unless the asset is insured, this will result in a loss to the bank. (4) The bank may be exposed to legal risk in respect of the enforcement of its contractual right to reposes the asset in case of default or misconduct by the lessee. This may be the case particularly when the asset s a house or apartment that is the lessee’s home and the lessee enjoys protection as a tenant.

(v) Musharakah: • Operational risks that may be associated with musharakah • investments are as follows: • The bank may not perform adequate due diligence in appraising the venture to be financed and the soundness and reliability of the customer. Lack of appropriate technical expertise can be a cause of failure in a new business activity. • (2) During the musharakah investment period, the bank may not carry out adequate monitoring of the financial performance of the venture, and may fail to receive adequate financial information in order to be able to do so.

(vi) Mudarabah: • Since this type of contract may be used on the assets side of the • balance sheet, as well as being used on the funding side for mobilizing • investment accounts, the operational risk is first analyzed from the • asset-side perspective and then from the funding-side perspective • (which is related to fiduciary risk). • (1) Asset-side Mudarabah – Contractually, the bank has no control over the management of the business financed through this mode, the entrepreneur having complete freedom to run the enterpeise according to his best judgment. The bank is contractually entitled only to share with the entrepreneur the profits generated by the venture acccording to the contractually agreed profit-sharing ratio. The entrepreneur as mudarib does not share in any losses which are borne entirely by the rab al mal. The mudarib has an obligation to act in a fiduciary capacity as the manager of the bank’s funds, but the situation gives rise to moral hazard especially if there is information asymmetry. Hence, in addition to due diligence before advancing the funds, the bank needs to take precautions against problems of information asymmetry during the period of investment.

(2) Funding-side Mudarabah – Since a mudarabah contract is employed between the Islamic bank and its investment account holders (IAH), the IAHs share the profit and bar all losses without having any control or rights of governance over the Islamic bank. • In return the bank has fiduciary responsibilities in managing the IAH’s funds typically expects returns on their funds that are comparable to the returns paid by competitors, but they also expect the bank to comply with shariah rules and principles at all times. If the bank is seen to be deficient in its shariah compliance, it is exposed to the risk of IAHs withdrawing their funds and, in serious cases, of being accused of misconduct and negligence. In the latter case, the funds of the IAHs may be considered to be a liability of the bank, thus jeopardizing its solvency.

TK 6413 / TK 5413 : ISLAMIC RISK MANAGEMENT