Risk characteristics of Islamic financial products

1. Risk characteristics of Islamic financial products • Institute of Islamic Banking & Insurance • London 15th December 2004 • Warren Edwardes, • ceo, Delphi Risk Management Limited • email: we@dc3.co.uk • web: dc3.co.uk Warren Edwardes

2. Delphi’s website contains: • articles on Islamic banking on:dc3.co.uk/islamicbanking • This PowerPoint is on:dc3.co.uk/islamicfinancerisk041215.ppt • with notes ondc3.co.uk/islamicfinancerisk041215.pdf • Speech drawn from the book "Key Financial Instruments" • Appendix 1 (50 Risk types) • dc3.co.uk/risks.htm • Appendix 4 (Islamic banking) • dc3.co.uk/islamicbanking.htm Warren Edwardes

3. financial risk • some actions can protect • the same actions can destroy • risk – a film Warren Edwardes

4. Warren Edwardes

5. Does Islamic banking risk differ from Conventional banking risk? • Not different - just a very special case • Trade credit ? • Asset backed Secured or unsecured ? • Debt or equity ? • Leasing ? • Repos / Murabaha ? • Fund management ? • Islamic Banking is ALL about who bears risk Warren Edwardes

6. A check-list of 50 banking risk types • To put it simply and directly, • if the bosses do not or cannot understand both the risks and rewards in their products, • their firm should not be in the business. - • William J. McDonough, President, Federal Reserve Bank of New York Warren Edwardes

7. banking risk types - 1-4 • Acquisition Risk • Different cultures between banks “consolidating” • Careless Error Risk • Human error should be forgiven. But this is not covered by law • Competitive Risk  • LIBOR determines competitors returns • Commodity Risk • If you take delivery can the commodity price be managed? Warren Edwardes

8. banking risk types - 5-8 • Communication Risk  • Define terms clearly • Deposit or managed funds? • Country Risk  • much of Islamic banking is carried out in emerging markets. Riskier? Pakistan is stable in the eyes of Mid East investors • Credit Risk • Not loans. Not IOUs. So equity not loan risk • Cultural Risk  • Difference between Gulf and Malaysia - narrowing Warren Edwardes

9. banking risk types – 9-12 • Currency Transaction Risk • use of derivatives generally not allowed? Cannot hedge exchange rate for purchases • Currency Translation Risk • Balance sheet value of dollar assets or liabilities fluctuate • Currency Economic Risk • Again no hedging permitted. So can Malaysia compete with USD based countries when the USD depreciates? • Customer Satisfaction Risk • If a bank pays no dividends customers will get angry Warren Edwardes

10. banking risk types - 13-16 • Disaster Recovery Risk • If a terrorist or earthquake strikes can you cope? • Economic Activity Risk • Applies when overheads are fixed. Outsourcing a solution • Energy Price Risk  • Many Islamic countries’ economies are linked to the oil price • Environment Risk • Are environment unfriendly policies haram? Warren Edwardes

11. banking risk types - 17-20 • Equity Market Risk  • Islamic banking is ideally profit and loss sharing. This is venture capital or equity investment • Fraud (banker) Risk • Transparency is required. Avoid the risk of misinterpretation and mis-selling • Fraud (customer) Risk • If an investor loses money will he seek redress? Of course if he wins he will not • Fraud (staff) Risk • Haram for lenders to seek material benefit. BCCI was not an Islamic bank but fraud could occur in Islamic banks Warren Edwardes

12. banking risk types - 21-24 • Image / PR Risk  • Something hallal could be deemed haram. Sep 11 was bad PR for Islamic banks • Information Risk  • Lack of transparency in accounts in many Islamic countries • Inflation Risk  • Securitised asset rises in value but not the repayment amount which being a cash amount depreciates. Time value of money? • Interest rate Risk  • This is not a closed economy. If interest rates rise sharply deposits will flow out. LIBOR linking Warren Edwardes

13. banking risk types - 25-27 • Interaction Risk  • Correlation risk. What happened in New York and Baghdad impacts on KL. Gold standard? • Language Risk  • Arabic, English, Malay, Indonesian, Urdu? Same word can have different meanings. • Legal Risk  • UK, Malaysian, .. Is the bank / customer permitted to carry out such business?. Ultra Vires issue Warren Edwardes

14. banking risk types - 28-30 • Liquidity Risk  • Major problem for Islamic banking is the absence of a developed Islamic money market. • about managing confidence and the liability side • About managing diversification. • Morbidity Risk • No different from conventional banking. What happens if there is an outbreak of dengue fever or Anthrax? • Mortality Risk  • Do you have offices in a tall building? • Would you survive major loss through fire? Warren Edwardes

15. banking risk types - 31-34 • Operational Risk • Are strong procedural systems in place? Really everything other than market risks • Performance Measurement Risk  • Most measures of performance are crude and slavish adherence to rules can lead to poor real performance • Political Risk  • Seizure of assets post Sep 11; boycotts by Western banks • Competence / Understanding  • Are the latest products really understood by the banks’ senior management? By the customers? Warren Edwardes

16. banking risk types - 35-38 • Concentration of assets Risk • A problem for Islamic funds. No tobacco, banking and alcohol stocks can lead to heavy weighting in property and technology • Concentration of liabilities Risk • Do you have enough investors or do you depend on one or two? • Concentration of business type Risk • Financial supermarket or nimble niche player are both fine. But can you reinvent yourself if markets change? • Can you cope with the entry of HSBC / Barclays / Citibank? • Convertibility Risk • Deliverability risk under exchange controls Warren Edwardes

17. banking risk types - 39-42 • Property (Real Estate) Risk  • Would asset backing be sufficient in times of a property crash? • Rating Agency Risk  • A downgrading or even credit watch can impact on liquidity and the entire business. Investment grade bonds do not default. They become junk and then default. • Regulatory Risk  • A firm operating globally will face different rules • Religious Risk  • A Hallal product may later be deemed Haram. Zero coupon bonds were once Hallal. Other than Malaysia no Central Shari’ah authority Warren Edwardes

18. banking risk types - 43-46 • Resignation Risk  • Over dependence on one person’s skills and market contacts? • Settlement Risk  • If there is no escrow account there is settlement risk on Murabaha and BBA • Systemic Risk  • Financial instability is contagious. Financial systems are closely inter-linked • Tax Risk  • Do the sale and repurchase transactions face VAT? Income tax or capital gains tax treatment? Warren Edwardes

19. banking risk types – 47-49 • Technological Risk  • Are your fax confirmations going to your customer or a competitor? • Transport Risk  • traffic jams may have led to cancelled meetings which may never be rearranged • Weather Risk  • Could you hedge against the weather? KL’s 1998 smog and Kuwait’s burning oil fields probably had an adverse impact on employees health. • Weather derivatives are being traded. Haram? Weather Takaful? Warren Edwardes

20. banking risk types – 50 • Zero Risk • It’s impossible to take an unnecessary risk. • because you only find out whether a risk was unnecessary • after you’ve taken it • Giovanni Agnelli, President FIAT Warren Edwardes

21. Particular Islamic banking risk issues • Liquidity– under developed money market • Interest rate Risk  • Commodity Risk • Communication Risk • Equity risk – fund management or banking? • Operational risk • Religious – Hallal or Haram? • Language Risk - English, Arabic, Malay or Urdu Warren Edwardes

22. Risk Issues In Islamic Banking Warren Edwardes