Risk issues with Islamic Banking

Risk issues with Islamic Banking • Warren Edwardes, ceo, Delphi Risk Management • 3rd International Islamic Banking, Finance & Insurance Conference • Ottawa Congress Centre, Ottawa, Canada • May 17th / 18th 2007 • Delphi’s Islamic banking articles (and this powerpoint) : dc3.co.uk/ibnews Warren Edwardes

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

Islamic Banking Risk • 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 / Ijara • Repos / Murabaha ? • Fund management ? • Islamic Banking is about who bears risk Warren Edwardes

Regulation • Basel II does apply • The Islamic Financial Services Board (IFSB) • www.ifsb.org • The Accounting & Auditing Organization for Islamic Financial Institutions, (AAOIFI) • www.aaoifi.com • Is it banking or financing? • A check-listof 50 banking risk types Warren Edwardes

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

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? UAE 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

banking risk types – 9-12 • Currency Transaction Risk • use of derivatives generally not allowed – changing • 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 • Customer Satisfaction Risk • If a bank pays no dividends customers will get angry • Moral hazard Warren Edwardes

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

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 • Gharar. 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 • BCCI was not an Islamic bank Warren Edwardes

banking risk types - 21-24 • Image / PR Risk • Something hallal could be deemed haram. • Information Risk • Was lack of transparency in accounts but AAOIFI is changing this • 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

banking risk types - 25-27 • Interaction Risk • Correlation risk. What happened in New York and Baghdad impacts on KL. • 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

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

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 • Competence / Understanding • Are the latest products really understood by the banks’ senior management? By the customers? Warren Edwardes

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 • Are there enough investors? • Concentration of business type Risk • Can a specialist Islamic bank compete with a full service bank? • Convertibility Risk • Deliverability risk under exchange controls Warren Edwardes

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. But less so now with Basel II / AAOFI / IFSB • Religious Risk • A Hallal product may be deemed Haram. Zero coupon bonds were once Hallal. No Central Shariah authority – ex Malaysia Warren Edwardes

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 sales tax? Income tax or capital gains tax treatment? Warren Edwardes

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? • Weather derivatives are being traded. Haram? Weather Takaful? Warren Edwardes

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

Conclusion: 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

My Book Warren Edwardes

Risk issues with Islamic Banking