Download Definition of Risk Risk can be defined as “uncertainty about financial

Definition of Risk
Risk can be defined as “uncertainty about financial loss from an exposure”. It can also be defined
as “the relative variation of actual from expected outcomes”.
Risk management can be defined as a process that identifies loss exposures faced by an
organization and selects the most appropriate techniques for treating such exposures; Risk
management is a formal process that enables the identification, assessment, planning and
management of risks.
All levels of an organization need to be included in the management of risk in order for it to be
effective; These levels are usually termed corporate (policy setting), strategic business (the lines
of business) and project. Risk management needs to take into consideration the interaction of
these levels and reflect the processes that permit these levels to communicate and learn from
each other.
The aim of risk management is therefore threefold. It must identify risk, undertake an objective
analysis of risks specific to the organization, and respond to the risks in an appropriate and
effective manner. These stages include being able to access the prevailing environment that
would impact on a project in hand or on a portfolio of projects.
Basically the Risk Management Process involves six steps of activities namely:
-
The setting up of risk management policies;
The identification of risk;
The evaluation of risk;
The development of a risk management plan to mitigate the risks i.e. through risk control
and risk financing mechanism;
The implementation of the risk management plan;
The review and monitoring of the risk management plan
Risk Identification:
 Identify risks of all business processes (From R&D to Customer Services).
 Identify risks by category: Finance/Operation/Strategic.
Risk Evaluation:
 Determine critical risks.
 Consider likelihood, business impact, and the current management level of risks.
Risk Monitoring:
 Continuous monitoring and control.
 Report the symptoms of risks.
 Collaboration among business units.
Risk Response & Reporting:
 Risk Response Activities (Risk Mitigation, and Risk Avoidance).
 Reporting to Risk Management Committee (Risk remediation activities, and Employee
training).
Enterprise Risk Management (ERM)
Due to rapid changes in the business environment with growing risks, many companies have not
been able to maintain their leading positions in the market.
 Organized Risk Management Committee consisted of experts from various departments
Performed risk assessment and risk mitigation activities

Focused on nine core risks; Raw material price, foreign exchange rate, crude oil
exploration and etc.

Executed quarterly risk assessment and control using early risk warning system.
For successful enterprise risk management, it is necessary to take an integrated perspective that
allows viewing the company as a whole. Moreover, a comprehensive approach to managing risk
requires effective and efficient efforts— throughout the business—that both mitigate risk and
improve overall business performance. Furthermore, companies need to focus on key risks and
enhance coordination of risk and control groups to achieve greater efficiencies.
Enterprise Risk Management (ERM)
Enterprise Risk Management: ERM deals with all risks critical to the maintenance and enhancement
of firm value. ERM seeks to address all of a firm’s risks with an organized, integrated and coherent
framework.
Enterprise risk management is a process, effected by an entity’s board of directors, management
and other personnel, applied in strategy setting and across the enterprise, designed to identify
potential events that may affect the entity, and manage risk to be within its risk appetite, to
provide reasonable assurance regarding the achievement of entity objectives.
The definition reflects certain fundamental concepts. Enterprise risk management is:
- A process, ongoing and flowing through an entity
- Effected by people at every level of an organization
- Applied in strategy setting
- Applied across the enterprise, at every level and unit, and includes taking an entity level
portfolio view of risk
- Designed to identify potential events that, if they occur, will affect the entity and to manage
risk within its risk appetite
- Able to provide reasonable assurance to an entity’s management and board of directors
- Geared to achievement of objectives in one or more separate but overlapping categories
The Evolution of Enterprise Risk Management
The term risk management relating to business risks first appeared in the 1950s; not until 1970
did non-financial businesses begin to practice risk management in a meaningful way;
Risk managers were overwhelmingly concerned with hazard risks and the purchase of insurance;
risk associated with the firm’s production processes were managed by operational managers, and
personnel risks were managed by human resources; little consideration was given to how
disparate risks related to each other, not to overall firm value.
An increasingly menacing political environment internationally in the late 1970s and 1980s
focused MNCs’ attention on political risks and how to manage them. Towards the end of the
1980s, MNCs and large national corporations in Europe and North America began creating
dedicated risk management departments. Nevertheless, the “silo” mentality and approach to
managing risks remained entrenched, with most efforts still dedicated to insurable risks only.
In the 1990s, managers of MNCs increasingly were feeling pressures from shareholders and
other stakeholders to do more than buying insurance against uncertain loss events and to
determine what risks were inherent in the firm’s core competencies and what were the means of
managing them to enhance enterprise value.
The issue of how simultaneously to operate more efficiently and minimize disruptions while
ensuring high quality become more critical than ever.
Managers have since been under pressure to gain a sophisticated understanding of the risks that
their organization faced.
By the close of the 1990, risk management has come to be more closely associated with the
collective management of financial, operational and strategic risks.
An appreciation began to down that risks cannot be easily isolated from one another.
Interactions were pervasive, yet formerly these interactions were largely ignored. Risk
management had moved from a cost center to a profit center in that the questions that boards
asked managers were less on “how can we lower the cost of insurance” to “how can we
holistically manage the corporation’s risks such that the overall risk profile is better positioned
for maximizing firm value”.
At about the same time, several highly publicized corporate malfeasance scandals shook public
confidence in corporations themselves, especially in securities market, and regulatory vigilance.
In response, laws were enacted, the effects of which were to force corporations to have stronger
corporate governance procedure in place. These requirements provided fuel to the ERM fire.
The Risk Management Fundamentals:
-
The Purpose of Risk Management
Risk management is most often associated with attempts to manage those risks that entail the
possibility of economic harm. From a financial viewpoint, “harm” is a reduction in the economic value
of a firm, which can be expressed as the value today of the firm’s expected future cash flows, including
its present assets.
Thus, the purpose of corporate risk management is to contribute the maximization of the economic
value of the firm where value is defined as the discounted value of expected future cash flows.
Risk management contributes to economic value by reducing economic harm. Economic harm can
arise in four ways:
o A reduction in the value of existing wealth;
o An increase in future expenditures;
o A reduction in future income;
o An increase in the discount rate;
-
The Goals in Risk Management
The overriding goal of ERM is to maximize the value of the firm by ensuring that this risk portfolio is
aligned with the firm’s risk appetite. A firm can alter its risk portfolio in three ways:
o Modify its operation;
o Adjust its capital structure; or
o Employ targeted financial instruments.
An effective ERM approach should be toward several sub-goals:
o Ensure that the firm’s risk appetite is aligned with its overall strategy;
o Enhance risk response decisions by providing the risk manager with the means to
manage multiple and cross-enterprise risks and tools to control or finance the risks;
o Reduce operational surprises and losses by enhancing the firm’s capability to identify
potential events and ensure adequate responses;
o Identify and act on (new) business opportunities from successfully managing risks;
o Allow management effectively to assess the firm’s capital needs and improve capital
allocation.
By managing all risks collectively, they expect cash flow improvements, particularly as relates to
achieve less volatility by reducing the weights on the tails of the cash flow distribution.
- The ERM Framework
The ERM framework developed by COSO consists of eight components: internal environment
analysis, objective setting, event identification, risk assessment, risk response, control activities,
information and communication, and monitoring. Of these, internal environment analysis is the
foundation of all other components. It involves an examination of the firm’s ethical values,
competence, human resources development, management style and corporate hierarchy.
The Australian /New Zealand Standard (AS/NZS 4360)
It consists of seven steps: communicate and consult, establish the context, identify risks, analyze risks,
evaluate risks, treat risks and monitor and review. The process emphasizes the importance of
establishing effective communications and consultations with all stakeholders as appropriate and at
each stage of the process. It stresses the importance of defining the relationship between the
organization and external environments, understanding the organization, defining the risk management
context and risk criteria.
The UK Risk Management Standard
This version of a risk management framework is no different in principle from those of COSO and
AS/NZS 4360. Nevertheless, the UK standard adds two distinctive features. It offers specifics as to the
duties of the board and senior management; business units and individuals for risk reporting and
communication. It also offers a basis with which a corporation develops its own risk map.
-
The Risk Management Process
• The ERM process is as follows
ERM Committee
(Senior Management, Board, Department Heads and Risk
Goal Setting
Risk Reporting and Communication
Environmenta
l
Analysis
Risk
Analysis
Risk
Response
Internal
Environment
Risk
Quantification
Risk Control
External
Environment
Risk Mapping
Risk Financing
Overview
The figure below offers a schematic illustration of the risk management process. It stresses on critical
areas such as:
1. Goal setting;
2. Risk reporting and communications;
3. Goal achievement
Environmental Analysis
The internal environment
Corporations rely on numerous techniques to assist them in conducting an internal analysis of their
risks that could materially affect firm value; some of the key sources for prompting consideration of the
Go
Pla
Ad
internal environment are: financial statements, income and cash flow statements, examination of
production operations, questionnaires, brainstorming sessions with key personnel, scenario planning.
Risks that can be identified from the internal analysis include:
Operational Risk, which arises from the activities and operations of the firm. It includes such as those
that arise from human errors, system failures, inadequate procedures and controls as well as
management miscalculations. Some generic aspects of operations subject to risk are as follows:
o Earnings;
o Assets;
o Employees;
o Legal liability;
o Political risks.
o Financial Risk, which arise from ownership or use of financial instruments. Financial
risks arise from many sources such as:
o Currency or foreign exchange rate risk;
o Interest rate risk;
o Input price risk;
o Output price risk;
o Credit or counterparty risk.
External environment
- Threats and opportunities external to the organization fall overwhelmingly into the strategic
risk category – risk cannot be directly controlled by the firm; strategic risks stem from
macroeconomic and other primarily external influences and trends.
-
Responsibility for managing strategic risks usually rest at the highest levels of the organization
for they have the potential to expose the enterprise to substantial shocks, even to the point of
financial failure.
Risk Analysis
- Analysis of quantitative risks:
o NPV
o IRR
o CAPM
o VaR
- Analysis of qualitative risks:
o Scenario planning;
o Brainstorming;
o Decision tree analysis;
o CART, HAZOP, PERT;
-
Risk mapping: involves the graphical positioning of events in terms of financial impact and
probability.
Risk Response
-
-
-
Risk control techniques
• Avoidance
• Loss prevention
• Loss reduction
Risk related management standards
International organization for standardization
• The ISO 9000 series:
• The ISO 14000 series;
• Agenda 21
Risk financing
•
•
•
•
•
Plan administration
•
•
- Monitoring
•
•
•
Internal loss financing / retention
External loss financing
Contractual transfer
Hedging
Insurance
Implementation
Modeling firm value
Decentralized risk management program
Centralized risk management program
Review
Enterprise risk management encompasses:
- Aligning risk appetite and strategy – Management considers the entity’s risk appetite in
evaluating strategic alternatives, setting related objectives, and developing mechanisms to
manage related risks.
- Enhancing risk response decisions – Enterprise risk management provides the rigor to identify
and select among alternative risk responses – risk avoidance, reduction, sharing, and acceptance.
- Reducing operational surprises and losses – Entities gain enhanced capability to identify
potential events and establish responses, reducing surprises and associated costs or losses.
- Identifying and managing multiple and cross-enterprise risks – Every enterprise faces a myriad
of risks affecting different parts of the organization, and enterprise risk management facilitates
effective response to the interrelated impacts, and integrated responses to multiple risks.
- Seizing opportunities – By considering a full range of potential events, management is
positioned to identify and proactively realize opportunities.
- Improving deployment of capital – Obtaining robust risk information allows management to
effectively assess overall capital needs and enhance capital allocation.
Components of Enterprise Risk Management

Internal Environment – The internal environment encompasses the tone of an
organization, and sets the basis for how risk is viewed and addressed by an entity’s
people, including risk management philosophy and risk appetite, integrity and ethical
values, and the environment in which they operate.

Objective Setting – Objectives must exist before management can identify potential
events affecting their achievement. Enterprise risk management ensures that management
has in place a process to set objectives and that the chosen objectives support and align
with the entity’s mission and are consistent with its risk appetite.

Event Identification – Internal and external events affecting achievement of an entity’s
objectives must be identified, distinguishing between risks and opportunities.
Opportunities are channeled back to management’s strategy or objective-setting
processes.

Risk Assessment – Risks are analyzed, considering likelihood and impact, as a basis for
determining how they should be managed. Risks are assessed on an inherent and a
residual basis.

Risk Response – Management selects risk responses – avoiding, accepting, reducing, or
sharing risk – developing a set of actions to align risks with the entity’s risk tolerances
and risk appetite.

Control Activities – Policies and procedures are established and implemented to help
ensure the risk responses are effectively carried out.

Information and Communication – Relevant information is identified, captured, and
communicated in a form and timeframe that enable people to carry out their
responsibilities. Effective communication also occurs in a broader sense, flowing down,
across, and up the entity.

Monitoring – The entirety of enterprise risk management is monitored and modifications
made as necessary. Monitoring is accomplished through ongoing management activities,
separate evaluations, or both.
Effectiveness of enterprise Risk Management:
Determining whether an entity’s enterprise risk management is “effective” is a judgment
resulting from an assessment of whether the eight components are present and functioning
effectively. Thus, the components are also criteria for effective enterprise risk management. For
the components to be present and functioning properly there can be no material weaknesses, and
risk needs to have been brought within the entity’s risk appetite. When enterprise risk
management is determined to be effective in each of the four categories of objectives,
respectively, the board of directors and management have reasonable assurance that they
understand the extent to which the entity’s strategic and operations objectives are being
achieved, and that the entity’s reporting is reliable and applicable laws and regulations are being
complied with.
The eight components will not function identically in every entity. Application in small and midsize entities, for example, may be less formal and less structured. Nonetheless, small entities still
can have effective enterprise risk management, as long as each of the components is present and
functioning properly.
Risk Management from Islamic Point of View
Concept of Risk in Islam
• Risk in Islamic term is Ghorm; it comes from the legal saying al-ghorm bil ghonm meaning no
pain no gain;
• In the history of Islam, there are many incidents that are closely related which can be used as a
benchmark. In facing and managing risk, several steps can be implemented:
• Risk avoiding
• Risk reduction
• Risk sharing
• Risk controlling
• Among the historical incidents that can be related to a risk management practice are:
• The hijrah of the Prophet (S.A.W) from Makkah to Madinah
• During the Battle of Badr;
• During the battle of Khandaq
• The principle of risk sharing was stated in the statute of Madinah;
The Principles in Islamic Risk Management
The Principles are grouped into six categories of risks, and shall be used as the basis for IFI’s risk
management process.
General Principle:
Principle 1:
IFI should have a comprehensive risk management and reporting process in place.
The process should consider appropriate steps to comply with Shariah rules and principles and to
ensure the adequacy of relevant risk reporting to the supervisory authority.
Credit Risk:
Principle 2:
IFI should have a strategy for financing; the
compliance with Shariah, whereby it recognizes the potential
different stages of the various financing arrangements.
instruments used must be in
credit exposures that may arise at
Principle 3IFI shall carry out a due diligence review in
respect of counterparties prior to
deciding on the choice of an appropriate Islamic financing instruments.
Principle 4IFI should have appropriate methodologies for measuring and reporting the credit risk
exposures arising under each Islamic financing instrument.
Principle 5IFI shall have in place shariah – compliant credit risk mitigating techniques appropriate
for each Islamic financing instrument.
Investment Risk:
Principle 6IFI should have appropriate strategies in place for risk management and reporting
processes in respect of the risk characteristics of equity investments, including Mudarabah and
Musharakah investments.
Principle 7IFI must ensure their valuation methodologies are appropriate and consistent, and they
should conduct the assessment on the potential impacts of their methods on profit calculations and
allocations. The methods shall be mutually agreed between IFI and the Mudarib and/or Musharakah
partners.
Principle 8IFI shall, in respect of their equity investment activities, including extension and
redemption conditions for Mudarabah and Musharakah investments, exit strategies
should
be
defined and established and must subject to the approval of the institution’s Shariah Board.
Market Risk:
Principle 9In respect of all assets held, IFI shall have an appropriate
framework for market
risk management (including reporting) and also for those that do not have a ready
market and/or
are exposed to high price volatility.
Liquidity Risk:
Principle 10- IFI shall have in place a liquidity management framework (including reporting) taking
into account separately and on an overall basis their liquidity exposures in respect of each category of
current accounts, unrestricted and restricted investment accounts.
Principle 11- IFI shall assume liquidity risk commensurate with their ability
recourse to Shariah-compliant funds.
to
have
sufficient
Rate of Return Risk:
Principle 12- A comprehensive risk management and reporting process
should be established
by IFI in order to assess the potential impacts of market factors affecting rates of return on assets in
comparison with the expected rates of return for investment account holders (IAH).
Principle 13- IFI must ensure that an appropriate framework for
commercial risk is in place, where applicable.
managing
displaced
Operational Risk:
Principle 14- IFI should have in place adequate systems and controls, including Shariah Board or
Advisor, to ensure compliance with Shariah rules and principles.
Principle 15providers.
IFI shall have in place appropriate mechanisms to safeguard
the interests of all fund
RISK CHARACTERISTIC OF ISLAMIC PRODUCTS
Credit Risk:

Murabahah and other sales-based facilities (Istisna’, Salam) together with lease-based facilities
(Ijarah) dominate the asset side of Islamic banks. Thus, credit risk in the normal sense- the risk
of losses in the event of default of the borrower or in the event of a deterioration of the
borrower’s repayment capacity is the most common source of risks in an Islamic bank.

Credit risk can be measured based on both the traditional approach that assigns every counter
party into a rating class, as well as more advanced credit VaR methods. The basic measurement
principle under both these approaches is to estimate the expected loss on an exposure owing to
specified credit events, and also to calibrate unexpected losses that might occur at some
probability level. Expected losses are provisioned and regarded as an expense that is deducted
from income, while unexpected losses are backed up by capital allocation.

The calculation of loss both expected and unexpected in an individual loan require the
estimates of: probability of default. Potential credit exposures at default. Loss-given default.

Losses will depend upon the potential credit exposures at the time of default or EAD. In
Murabaha, and Salam contracts EAD in most cases would be the nominal value of the contract.
In long term Ijarah and Istisna’ contracts, EAD will depend upon projected environmental
factors that will be facility-specific.

Losses will ultimately depend upon the rate of recovery following default, or the reduction in
the value of the loan if ratings change.

Loss given default (LGD) is likely to depend upon ease of collecting on the collateral, the value
of the collateral, the enforceability of guarantees, and on legal environment that determines
crditors’ rights and the features of insolvency regime. .

The inability of Islamic banks to use penalty rates as a deterrent against late payments could
create both a higher risk of default and longer delays in payments, and finally the limitations on
eligible collateral under Islamic finance or excessive reliance on commodities and cash
collateral may increase credit risks generally, and reduce the potential recovery value of the
loan.

In cases where Mudarabah is used in project finance, an Islamic Financial Institution advances
funds transfer to a customer who acts as Mudarib in a construction contract for a third-party
customer (ultimate customer). The ultimate customer, who has no direct or contractual
relationship with the IFI, will make progress payments to the Mudarib who in turn make
payment to the IFI. The role of the IFI is to provide bridging finance on a profit-sharing basis
to the Mudarib pending his receipt of the progress payments from the ultimate customer. The
IFI is exposed to credit risk on the amounts advanced to the Mudarib.
Investment Risk: (Equity Risks)

Investment risk can be defined as the risk arising from entering into a partnership for the
purpose of undertaking or participating in a particular financing or general business
activity as described in the contract, and in which the provider of finance shares in the
business risk. Investment risk is exposed to a group of risks that are associated with
Mudarib or Musharakah partner, business activity and operations.

The possible unexpected losses in such equity-type contracts will depend upon the functions of
the underlying enterprise or venture in which the bank requires an equity exposure.

High-quality monitoring would be very important in Islamic banks, since the finance
provider cannot interfere in the management of the project funded on a Mudarabah basis.
In the case of Musharakah, the equity risk may be less, in so far as the bank exercises
some management control.

Profit sharing approaches of Mudarabah or Musharakah will be used in evaluation process of
Investment risk where the risk profiles of potential partners (Mudarib or Musharakah partner)
are among the crucial considerations for the undertaking of due diligence. These risk profiles
include the past record of the management team and quality of the business plan of, and human
resources involved in, the proposed Mudarabah or Musharakah activity.

Mudarabah or Musharakah financings can be differentiated in terms of IFI’s involvement in
the investments during the contract period. In Mudarabah, the IFI invest their money as silent
partners and, the management is the exclusive responsibility of the other party, namely the
Mudarib. In contrast, in Musharakah financing the IFI (and its partner or partners) invest their
funds together, and the IFI may be silent partners, or may participate in management.
Regardless of their authority under which the profit sharing instruments are used, both
Mudarabah and Musharakah are profit-sharing financings, under which the capital invested by
the provider of finance does not constitute a fixed return, but is explicitly exposed to
impairment in the event of losses (capital impairment risk).
Market Risk:

Market risk is defined as the risk of losses in on-and off-balance sheet positions arising from
movements in market prices i.e. fluctuations in values in tradable, marketable or leasable assets
(including sukuk). The risks relate to the current and future volatility of market values of
specific assets (for example, the commodity price of a Salam asset, the market value of a sukuk,
the market value of Murabahah assets purchased to be delivered over a specific period) and the
foreign exchange rates.

In Salam contract, IFI are exposed to commodity price fluctuations on a long position after
entering into a contract and while holding the subject matter until it is disposed of. In the case
of parallel Salam, there is also the risk that a failure of delivery of the subject matter would
leave the IFI exposed to commodity price risk as a result of the need to purchase a similar asset
in the spot market in order to honor the parallel Salam contract.

In Ijarah contract, a lessor is exposed to market risk on the residual value of the leased asset at
the term of the lease or if the lessee terminates the lease earlier (by defaulting), during the
contract. The lessor will be exposed to marker risk on the carrying value of the leased asset (as
collateral) in the event that the lessee defaults on the lease obligations.

In order to effectively those approaches in market risk, Islamic Financial Institutions should
have a good and comprehensive market risk management process and information system,
which includes:
• A conceptual framework to assist in identifying underlying market risks;
• Guidelines governing risk taking activities in different portfolios and their
market risk limits;
• Appropriate frameworks for pricing, valuation and income recognition; and
• A strong Management Information System (MIS) for controlling, monitoring
and reporting market risk exposure and performance to appropriate levels of
senior management.
Liquidity Risk:

Liquidity risk is interpreted in numerous ways, such as extreme liquidity, availability of liquid
assets to meet liabilities, and the ability to raise funds at normal cost. This is a significant risk in
Islamic banks owing to the limited availability of Shari’ah-compatible money market
instruments and lender of last resort.

A standard measure of liquidity risk is the liquidity gap for each maturity bucket and in each
currency, and the share of liquid assets to total assets.

Specific aspects of Islamic contracts could increase the potential for liquidity problems in
Islamic banks. These factors include: cancellation risks in Murabaha, the Shari’ah requirement
to sell Murabaha contracts only at par, the illiquidity of commodity markets, and prohibition of
secondary trading of Salam or Istisna’ contracts.

Liquidity risk is a financial risk due to uncertain liquidity. An institution might lose liquidity if
its credit rating falls or it experiences sudden unexpected cash outflows, or some other event
causes counterparties to avoid trading with or lending to the institution. A firm is also exposed
to liquidity risk if markets on which it depends are subject to loss of liquidity.

Liquidity risk tends to compound other risks. If a trading organization has a position in an
illiquid asset, its limited ability to liquidate that position at short notice will compound its
market risk. Suppose a firm has offsetting cash flows with two different counterparties on a
given day. If the counterparty that owes it payment defaults, the firm will have to raise cash
from other sources to make its payment. Should it be unable to do so, it will result to default.
Therefore, in this case, liquidity risk is compounding credit risk.

Risk sharing approaches used in managing liquidity risk, highlights the key elements for
effective liquidity management within the scope of IFIs’ exposures. IFI solicit and attract
various sources of funds to channel to their financing and investment activities. IFI may have
various kinds of obligations, such as requirements to repay current account holders on demand,
to provide committed funds in Musharakah transaction, and to make available cash flows for
expenses or profit payments.

In liquidity risk, approaches of risk sharing will be explained in view of two types of fund
providers which are current account holders and unrestricted investment account holder
(IAH). These account holders require a certain level of liquidity to be maintained by the
Islamic Financial Institution to meet their requirement for withdrawal. Subject to contractual
conditions, restricted IAH may also give rise to liquidity management considerations, in so far
as IFI may need to replace funds withdrawn by an investor pending realization of the related
assets.

As current account holders do not participate in the profits of the IIFSs’ business activities, a
sound repayment capacity is required to meet fully cash withdrawal requests as and when they
arise. IFI might depend heavily on funds provided by current account holders. Repayment by
the IFI of the principal amounts deposited by current account holders is guaranteed without any
rights to share in profits, as the current account holders do not share in the risks of the IFI.
Unrestricted IAH are investors who participate in the uncertainties of IFI’s business.
Therefore, they share in profits and bear losses arising from investments made on their behalf,
to the extent of their share. Apart from general withdrawal needs, the withdrawals made by
IAH may be result of lower than expected or acceptable rates of return and concerns about the
financial condition of the IFI and also due to non-compliance by the IFI with Shariah rules and
principles in various contracts and activities.

Rate of Return Risk:


Rate of Return Risk is a risk when the return may not meet an investor’s expectations. Most
often relates to equity investments where the return is never guaranteed and can only be
measured once the investment is sold. Interest rate risk is when the IFI are concerned with the
result of their investment activities at the end of the investment-holding period where such
results cannot be pre-determined exactly.
A rate of return risk is also involved when the IFI might be under market pressure to pay a
return that exceeds the rate that has been earned on assets financed by IAH when the return on
assets is under-performing as compared with competitors’ rates. IFI may decide to waive their
rights to part or their entire Mudarib share of profits in order to satisfy and retain their fund
providers and dissuade them from withdrawing their funds. Displaced commercial risk derives
from competitive pressures on IFI to attract and retain investors (fund providers). The decision
of IFI to waive their rights to part or all of their Mudarib share in profits in favor of IAH is a
commercial decision, the basis for which needs to be subject to clear and well defined policies
and procedures approved by the IFI’s Board of Director.

A profit Equalization Reserve (PER) is the amount appropriated by IFI out of their gross
income, before allocating the Mudarib share, in order to maintain a certain of return on
investment for IAH and increase owner’s equity. The basis for computing the amounts to be so
appropriated should be pre-defined and applied in accordance with the contractual conditions
accepted by the IAH and after formal review and approval by the IFI’s Board of Director.

An investment Risk Reserve (IRR) is the amount appropriated by IFI out of income of IAH,
after allocating the Mudarib share, in order to cushion the effects of the risk of future
investment losses on IAH. The terms and conditions whereby IRR can be set aside and utilized
should be determined and approved by the Board of Directors.

Another source of risk is the possible loss due to a change in the margin between domestic rates
of return and the benchmark rates of return such as LIBOR, which may not be closely linked to
the domestic return. This is a form of basis risk that should be taken into consideration in
computing the rate of return risk in the banking book.
Operational Risk:

As defined by Risk Management Group (RMG) of the Basel Committee and industry
representatives, operational risk is the risk of loss resulting from inadequate or failed internal
processes, people and systems or from external events. In other words, it is a risk associated
with failures in operations that are caused by people, processes or technologies.

Operational risks in Islamic banks include the following:





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The cancellation risks in non-binding Murabaha and Istisna’ contracts.
Problems in internal control systems to detect and manage potential problems in
operational processes.
Technical risks of various sorts.
The potential difficulties in enforcing Islamic finance contracts in a broader legal
environment.
The risk of non-compliance with Shari’ah requirements that may impact permissiable
income.
The risk of misconduct and negligence.
The need to maintain and mange commodity inventories often in illiquid markets.
The potential costs and risks in monitoring equity-type contracts and the associated
legal risks.
In operational risk, the risk sharing approach is applied in compliant with Principle 15 that is
IFI shall have in place appropriate mechanisms to safeguard the interests of all fund providers.
IFI shall establish and implement a clear and formal policy for undertaking their different and
potentially conflicting roles in respect of managing different types of investment accounts. The
policy related to safeguarding the interests of their IAH may include the following:
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Identification of investing activities that contribute to investment returns and taking
reasonable steps to carry on those activities in accordance with the IFI’s fiduciary
accordance with the terms and conditions of their investment agreements;
Allocation of assets and profits between the IIFS and their IAH will be managed and
applied appropriately to IAH having funds invested over different investment periods;
Determination of appropriate reserves at levels that do not discriminate against the right
for better returns of existing IAH; and
Limiting the risk transmission between current and investment accounts.
Adequate disclosure of information should be done by IFI on a timely basis to their
IAH and the markets in order to provide a reliable basis for assessing their risk profiles
and investment performance.
In the case of specific investments or financing such as Musharakah, IFI shall ensure
that the risks arising are monitored and reported at the group level (risk management on
a consolidated basis). An investment loss arising in a subsidiary or special purpose
vehicle may give rise to another related risk that is reputational risk.
Risk Identification in Islamic Financial Products
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; because each group has been concerned with a somewhat different problem, the strategies
and techniques they have adopted for identifying hazards have also differed;
Initially risk identification was an instinctive process; however now it is more structured and proactive
in nature.
Risk Identification Techniques includes the following:
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Orientation
Analysis of Documents:
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Analysis of Financial Statements
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Flow charts of the operations
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Organization Charts
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Existing Policies
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Loss Reports
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Contracts & Leases
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Other Documents
Interviews
Inspections
In permanent Musharakah the financial institution is also sharing the business profits. However, the
business may default to provide the expected cash. Such cases give birth to credit risk exposure.
As a result, to the above-mentioned credit inability the financial institution may face an exposure to
liquidity risks as it may not be able to provide enough cash for its other investments and activities.
Finally any major losses may cause inability for further continuation of the business. Such an event
may result in a last equity payment that will have a market price lower than the initial nominal one. In
this case the financial institution is exposed to market risk.
In permanent Musharakah contracts the financial institution has a partnership in the business. Thus any
external events or any inadequate activities or failures due to business risks that cause losses will
initiate an exposure to operational risks. Moreover, the Islamic bank may not perform adequate due
diligence in appraising the venture to be financed and the reliability of the customer. During the
Musharakah investment period, the bank may not carry out adequate monitoring of the financial
performance of the venture.
In diminishing Musharakah if the partner is unable to buy the equities on the pre-fixed price, due to
business failures, the financial institution is exposed to operational risks.
The above-mentioned default on the expected payment results in credit risk exposure in financial
institutions.
Credit and operational risks in diminishing Musharakah result in losses and variations to the financial
institution’s cash expectations, which means that it will exposed to liquidity risks due to the inability to
provide cash for any further investment activities.
In diminishing Musharakah the price of the equity is fixed and any mismatch between tha actual
market price and the fixed one may result in loss of potential profit. In this case the institution is
exposed to market risk.
Mitigations of risks in Musharakah
Operational risk management: financial institutions that have rights in management of such business
partnerships can participate in the business or monitor the process of the business and thus minimize
the associated risks.
Credit risk management: financial institutions can minimize credit risks by being involved in
business management activities and monitoring the balance of the business profits and losses.
Moreover, the sale of last equity is a type of guarantee for minimizing the loss of credit risks. Finally
financial institutions can minimize credit risks in diminishing Musharakah by having the rights to sell
their equities to a third party.
Market risk management: the stop loss should be clearly defined for selling the last equity price.
Static and dynamic analysis can be applied to estimate the current and future value at risk and evaluate
the significance of the market risk exposure. Finally, in diminishing Musharakah financial institutions
should set the payment for the equity sale to the partner on several preset installments.
Liquidity risk management: the liquidity risk is a result of other risks and financial institutions may
avoid facing such risks by either managing the source of the risk or by reserving additional capital.
Mudarabah
Risk issues during the investment period of the Mudarabah contract:
Operational risk may arise due to external events, as well as internal business failures. Such events
cause high disruptions for business development and result in losses, which must be covered by the
financial institution. Moreover, if the Islamic bank acts as Rab Al-Mal then it has to implement due
diligence before advancing the funds, and take precautions against problems of information
asymmetry. If the Islamic bank acts as Mudarib, then the Islamic bank has fiduciary responsibilities in
managing the IAHs’ funds, and has to comply with Shari’ah rules and principles at all times.
As a result of covering the above-mentioned losses, the financial institution is exposed to liquidity risk.
This is due to the fact that it has to cash out a capital above its expected lines and plans, and thus it will
not be able to fulfill other financial obligations.
Major losses may result in the inability of the business partner to carry on the business development. In
this case, the financial institution is facing a liquidity as well as credit risk due to the defaults from the
partner for providing the expected future cash flows.
Risk issues during the profit and loss period of the Mudarabah contract:
Any inadequate activities or failures by the agent during the business processes and activities will
expose the financial institution to business and operational risks.
Financial institutions are expecting profits from the Mudarabah contracts. As a result of the abovementioned losses the investors will be unable to provide the expected profit. Thus, the financial
institution will be exposed to credit risk due to the default on the expected cash flows.
The above-mentioned risk will expose the financial institution to liquidity risk as it will be unable to
provide enough cash for its other investments and activities.
Major losses in the Mudarabah contracts may cause the inability of the financial institution to provide
additional funds. In this case, this will result in a last equity payment to the investment’s equity
shares. As a result, the equity price will most probably have a market price lower than the initial
nominal one. This will expose the financial institution to market equity risk.
In Mudarabah contracts the financial institutions have no management rights on the partnership
business. These limitations may cause a transparency risk that would result in losses to the financial
institution.
Mitigation of risks in Mudarabah
Operational risks management: Financial institutions must ensure that the business deals using the
Mudarabah contracts are driven by experienced and knowledgable agents in order to minimize
operational risks.
Credit risks management: it can be minimized by monitoring the business performance and the
balance sheet of the business profits and losses.
Market risks management: financial institutions should define strategies that will be implanted for
the case of market risk. For instance the stop loss for selling the last equity price should be defined.
Liquidity risk management: the liquidity risk can be minimized by providing capital adequacy based
on either regulators directives or on internal estimations.
In Murabaha contracts the financial institution may not receive the payment from the client at the
agreed cycle repayment installment or at the maturity date. Thus such default will expose the financial
institution to credit risks. At this point the financial institution is also exposed to liquidity risk, because
of not receiving cash that it may use to cover other financial obligations.
Moreover, in non-binding Murabaha a customer may cancel the agreement to purchase; the IIFS has to
sell the goods in the open market at a selling price that can be lower than the purchase price, which
exposes it to market risk. Moreover, during the period when the commodity is in the possession of the
Islamic bank, the financial institution is exposed to any risk from the commodity’s price fluctuations,
which is related to market risk as well.
The financial institution is responsible for damages defects and spoilages to the commodity until it is
delivered to the buyer. This exposes the Islamic financial institution to operational risk. Furthermore,
the different viewpoints of Murabaha permissibility can be a source of operational risk. In addition, at
the contract signing stage, since the contract requires the Islamic bank to purchase the asset first before
selling it to the customer, the bank needs to ensure that the legal implications of the contract match the
commercial intent of the transactions.
Mitigation of risks in Murabaha
Operational risks management: this is whether the client will keep his promise of buying the product
or not. The financial institution can take a collateral security to guarantee the implantation of the
promise.
Credit risks management: the financial institution can accept from the buyer goods or other assets as
collaterals against credit risks.
Commodity risks management: the financial institution can use different scenarios that are driven by
dynamic simulations of the market behavior to estimate the future commodity prices.
Liquidity risks management: financial institutions should invest in efforts to mange other types of
risks and thus minimize exposure to liquidity risks.
In Salam contracts the Islamic financial institution is exposed to the settlement/delivery risk where
goods are not delivered, or not delivered on time, or not according to specifications. In this case, the
financial institution may have some losses due to exposure to operational and credit type of risks.
On the selling date any default from the buyer to buy the commodity at the agreed price exposes the
financial institution to the credit risk.
Delayed delivery may result in reputational risks as well as additional expenses. Moreover, the Salam
contracts expose the financial institution to commodity price volatility during the period between the
delivery of the commodity and the sale of the commodity at the prevailing market price.
Moreover, in cases of delivery defaults by the seller there is a liquidity risk as it expects cash-flow that
may not be received at the future selling time.
Inability to forecast and estimate the future price of the commodity based on benchmarks and mark-ups
could expose the financial institution to reinvestment risk and the IIFS may not be able to re-sell the
commodity at a profitable price.
As for operational risks the Islamic bank has to accept the goods that are the subject-matter of the
contract even though they are delivered early. The Islamic bank may have to reject goods of an inferior
quality to that specified in the contract, or accept them at the original price. For Salam with parallel
Salam the IIFS may face legal risk if the goods cannot be delivered at the specified time.
Risk mitigation in Salam contracts:
Operational risks management: the financial institution can minimize operational risks by
asking from the seller guarantees that they are following a quality management system or
following any standard system. Or they can collateralize their losses via insurance policies.
Credit risks management: financial institutions should apply approaches for estimating the
probability of default and the results from such credit risks and expected losses. Such approaches
may be based on quantitative information that are combined with qualitative criteria.
Market risks management: by evaluating the future market price based on different scenarios
and strategies, financial institutions can minimize their exposure to market risk and mark-up risk.
Moreover, static and dynamic analysis can be applied in evaluating the market risk in Salam
contracts.
Liquidity risks management: financial institutions should invest in efforts to mange other types
of risks and thus minimize exposure to liquidity risks.
In Istisna’ contracts the Islamic financial institution may deal with a customer who is unable to
honor the payment obligation for deferred installments or progress billings, which will expose
the Islamic bank to credit risk.
In Istisna’ with parallel Istisna’ the constructor may default on carrying the process of
producing the commodity/asset. Or may default on delivering the agreed commodity/asset on
time by delaying the production process and shifting the delivery date after the selling time
agreed between the financial institution and the buyer. Or the constructor may default in reaching
the agreed quality of the goods. Such defaults result in a credit risk exposure.
Any default on delivery will expose the financial institution to liquidity risk as it will not receive
cash flow at the future selling date.
Credit exposures are also arising at the selling time when the financial institution is not receiving
the selling price of the asset from the customer.
Istisna’ with parallel Istisna’ contracts may also expose the financial institutions to market risk,
if the customer under the direct Istisna’ defaults on the contract and the IIFS has to find another
purchaser for the asset at a price lower than the original contract price. Moreover, the IIFS is
exposed to market risk because the price of a commodity or a construction is fixed on the deal
date. However, at the delivery date, due to market price fluctuations, it may result in a
differentiation from the actual market price. This will result in the financial institution being
unable to sell the commodity at a profitable price.
As for operational risks the Islamic bank may be unable to deliver the asset on time, owing to
time overruns by the sub-contractor under the parallel Istisna’. Moreover, cost overruns under
the parallel Istisna’ contract may have to be absorbed partly or wholly by the Islamic bank. If the
sub-contractor turns out to be unable to complete the work, the bank will need to find a
replacement, which can be very difficult.
Risk mitigation in Istisna’ contracts:
Operational risk management: it can be minimized by monitoring the process of the
manufacturing or construction. Moreover, the financial institution should receive guarantees
from the manufacturers on whether they are following any standard system.
Credit risk management: financial institutions must be able to estimate the probability of
default and the expected losses resulting from the credit risk based on qualitative criteria as well
quantitative information data.
Market risk management: it can be minimized by selling the commodity or asset before the
delivery date. Moreover, it can be minimized by evaluating the future market prices of the
commodity/asset. Also static and dynamic analysis can evaluate the significance of the market
risk. Finally, the payment installments should be on a variable basis.
Liquidity risk management: financial institutions should reserve adequate capital for covering
such liquidation issues.
In operating Ijarah and IMB contracts the customer (lessee) may be unable to service the
lease rental when it falls due, and thus defaults on this obligation. Thus, such cases of inability to
re-pay by the lessee are exposing the financial institution to credit risks.
In the case of the lessee exiting earlier before maturity date will result in the financial institution
losing the expected payments on the pre-defined installments or at the maturity date. Thus, any
early leave exposes the financial institution to credit risks.
As a result of the above, risks there will be exposure to liquidity risks at the times where cash
flows were expected from the installment payments, or the fixed payment.
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 the asset at a lease rental lower than the originally agreed
total rentals. This exposes the IIFS to market risk. Moreover, the IIFS will bear the potential loss
due to the fair value of the asset falling below its residual value.
The value of the payments of rent in Ijarah contracts is defined on cycle payment installments
and is based on benchmark analysis. However, when such estimation is unable to fulfill the
actual market price, the financial institution will be exposed to market risk.
The Islamic bank needs to ensure that the asset will be used in a Shari’ah-complaint manner. If
the lessee damages the assets in its possession, the Islamic bank may face refusal by the lessee to
make the damage good. In this case, the bank needs to be able to repossess the asset and to take
legal action against the lessee to recover the damages. External events could also cause damage
to the assets that may initiate major losses, and the financial institution will be exposed to
operational risk. When the asset is returned to the financial institution any damages to the assets
may cause an associated loss. In such cases there will be exposure to operational risks once
more. The Islamic bank may be exposed to legal risk in respect of the enforcement of its
contractual right to repossess the asset in case of default or misconduct by the lessee.
In Ijarah wa Iqtina, the financial institution might be exposed to market price risk as the price of
selling the asset to the renter at the maturity date is pre-determined. The price at the maturity date
may differ from the actual market price.
In Ijarah thumma al-bai, the financial institution might be exposed to market risk as the lessee
may refuse to purchase the asset on the termination of the lease.
Mitigating risks in Ijarah contracts:
Credit risk management: guarantees and collaterals may be applied for minimizing the
financial institution’s exposure to credit risk.
Operational risk management: adequate insurance against any losses and damages to the asset
should be defined.
Market risk management: simulating and evaluating the future market price based on different
market scenarios and strategies that are driven by yield curves and VaR analysis.
Liquidity risk management: a good practice to minimize the liquidity risk is to monitor and
manage its causes from other risks.
Measurement of credit risk
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.
In the structure of the Islamic financial products, counterparties are all the parties that are involved in
the Islamic contract agreements and partnership. Thus,
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In Murabaha and Salam contracts – alongside the banks, both the seller and buyer are
considered as counterparties;
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In Ijarah contracts – the renter/lessees;
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In Istisna’a contracts – the buyer, user contractor or manufacturer
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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.
Financial problems related to either the individual counterparties or to more general economic
situations may be some of the reasons for the obligors to default.
In credit risk exposure analysis, a key factor is the identification of the relations between the
counterparties, the Islamic financial contracts and the guaranties and collaterals used to cover a
percentage of the potential losses in the case of defaults. More analytically, each contracts; moreover, it
may be linked with other counterparties defined as guarantees and collaterals;
From the above counterparty analysis the following points should be considered:
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The market conditions and the institutions strategies that may influence the counter play’s
behavior;
The type and the volume of the contracts where the counter play 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.
Traditionally, majority of financial analyst used their subjective analysis or judgmental approach to
assess credit risk. They used information from different obligor characteristics and the result was the
subjective opinion of an expert to approve or not a loan.
Now, credit institutions are not so much based on the relationship with their customers, but are
basically using the technology and are developing sophisticated models to upgrade their credit risk
management system.
Rating agencies such as Moody’s and S&P are in the business of providing ratings describing the
creditworthiness of corporate bonds.
A credit rating is designed to provide information about the default probabilities; as such one might
expect frequent changes in a company’s credit rating as positive and negative information reaches the
market; in fact, ratings change relatively infrequently; when rating agencies assign ratings, one of their
objectives is ratings stability.
Most banks have procedures for rating the creditworthiness of their corporate and retail clients. Using
the internal ratings based (IRB) approach in Basel II allows banks to use their internal ratings in
determining:
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The probability of default(PD);
The loss given default (LGD);
The exposure at default (EAD);
The maturity (M);
Internal ratings based approaches for PD typically involve profitability ratios, such as return on assets,
and balance-sheet ratios such as the current-ratio and the debt-to-equity ratio.
CREDIT RISK ASSESSMENT MODELS
Credit risk can be assessed using:
Qualitative methods: Qualitative methods are defined systems based on the judgment of experts who
are involved in the credit-approval process. The expert systems developed combine the analysis of the
credit worthiness of the obligor with the practical experience and observations of the experts who apply
the analysis;
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The credit risk assessment based on qualitative criteria involves the following steps:
1. The experts are rating the obligor based on predefined qualitative credit worthiness characteristics
together with some additional factors that may influence the client’s behavior.
2. The links for the ratings are defined in a qualitative manner that is determined by the experts.
3. The qualitative base risk grade drives the level of risks.
4. The individual grades are aggregated to generate an overall assessment.
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In the case of the Murabaha contract the ‘experts’ are facing the challenge of how to identify
the criteria that will evaluate whether the client will comply with the agreed payment
obligations that are set as installments on fixed time buckets.
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In Ijarah contracts, the lessee (financial institution) should define rules and criteria that are
related to future behavior of the lessor that may expose the institutions to credit risk; and its
dependency on the external factors (market, business and operational).
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In the Mudarabah and Musharakah contracts, the qualitative criteria that financial institutions
may define and apply to assess the credit risk exposure are more subjective and more complex.
The default on expected cash flows is mostly related to the actual resulting business profit,
where the financial institution may be directly or indirectly responsible.
Quantitative methods: Quantitative methods on the other hand are based either on statistical models
or on causal models; the statistical models can be in the form of: Univariate analysis; Discriminant
analysis, and Logistic regression models. As for causal models they derive credit ratings using a
theoretical business-based model and use only a few input parameters without explicitly taking
qualitative data into account;
These methods are based either on statistical models or on causal models. Each model is built under
several assumptions. So, it is only logical to say there is a level of uncertainty that can influence the
following:
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The model result;
The factors that might not be predicted;
The correctness of the estimation of parameters;
How close the model to reality
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Statistical Models:
In the construction of the quantitative models, risk analyst should follow process with certain
steps namely:
 Identifying the availability and accessibility of historical data, data clearance,
unification and selection to be used for credit financial risk analysis.
 Simulating data used for the credit financial risk analysis.
 Determination of model methodology.
 Assessment of the parameters of the model.
 Qualitative and quantitative validation.
 Conclusions.
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Univariate analysis looks at the central tendency of the values as well as at the dispersion. The
analysis includes tests that compare samples from different groups; it evaluates one variable of
interest and then compares it with another group it terms of its means, variance and the like.
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It uses t-test if data is approximately normal; the Mann-Whitney U-test for non-parametric tests
and other tests to compare two samples such is the Chi-Square test or the KolmogorovSmirnov test;
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Discriminant Analysis: In its basic form, discriminant analysis seeks for a linear function of
variables that best distinguishes between two or more predefined groups of obligors. If the two
groups are predefined – good and bad debtors – then we seek the function of financial ratios
that best distinguishes between solvent and distressed obligors.
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Logistic Regression Model: In these models, the Binomial Logistic Regression or Multi
nominal Logistic Regressions are applied to credit-assessment procedures; the objective is to
use certain credit-worthiness Characteristics (independent variables) to determine whether
borrowers are classified as solvent or distressed (dependent binary variable).
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Causal models derive credit ratings using a theoretical business-based model and use only a
few (exclusively quantitative) input parameters without explicitly taking qualitative data into
account. The most prevailing class of causal models is option-pricing models as proposed by
Merton and Black & Scholes.
Hybrid models: The hybrid forms of credit-assessment models are combinations of empirical
(or expert) models and one of the other two model types-statistical and causal; three types of
hybrid model types: Horizontal linking of model types; Overrides; and Knock-out criteria.
CREDIT RISK EVALUATION
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The main parameters that should be considered in the valuation of credit risks are the expected
and unexpected losses. The calculation of the expected and unexpected losses require the
calculation of the probability of default (PD), the loss given default (LGD), and the exposure at
default (EAD).
Defaults:
In general, default occurs when there is a loss that is initiated from the counterparty’s inability
to comply with its obligations. Specifically, for the typical Islamic financial contracts the
probability of defaults occurs in the following circumstances:
For Murabaha contracts, it is likelihood that the buyer of the goods (counterparty) will be
unable to repay the installments that he/she is obligated to.
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For the Ijarah contracts, it is the probability that the lessee (counterparty) will be unable to
repay at installment points or at the end of the contracts. Moreover, it could be the probability
of an early leave, from the lessee side, before the contracts maturity date.
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For the Salam contracts, it is the probability from the seller’s (counterparty) side to default on
delivering the commodity at the delivery date. On the other hand, it is also the default
probability from the buyer to buy the commodity at the agreed price.
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Similarly, for the istisna contracts, from the manufacturers and/or constructors side, it is the
likelihood of default on delivering the commodity or constructed asset at the delivery date.
Moreover, for the financial institution, it is the probability of not receiving the agreed selling
price from the buyer or user.
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In the Permanent Musharakah contracts of partnership where the business partners have the
role of the counterparty, it is the likelihood for the business to default in providing the expected
cash. However, in the Diminishing Musharakah contracts, it is the probability that the partners
default on buying the equities at the agreed prefixed price using the installment basis.
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In the Mudarabah contracts of partnership agreement and during the investment period, it is the
probability that the business venture defaults in carrying on the business development and/or
the project’s implementation. Moreover, during the profit and loss period it is the likelihood
that the business venture defaults in providing the expected profit.
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The estimation of the PD for the Islamic financial products is one of the most challenging
issues for financial institutions. The main steps that are commonly used for this purpose are:
 Analyzing the credit risk aspects of the counterparty;
 Mapping the counterparty to an internal risk grade which has an associated PD; and
 Calculate the PD.
For the different types of financial Islamic contracts, and their underlying assets, the definition
of their defaults on, for example, payment, delivery, expected profit, is based on criteria that are
delivered either from the financial institutions or from the regulators.
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The ‘materiality’ is another point that must be clarified in order to provide a concrete definition
of the probability of default. The ‘materiality’ notion coincides with the meaning of
‘substantiality. The most common implied definition that bans consider as ‘material’ is the fact
that the debtor is unable or unwilling to pay the installments to buy or to deliver the assets as
agreed for more than μ consecutive months (usually μ is set as 3 or 6 months). This is the level
after which the ‘road’ to default is irreversible for a certain confidence level.
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The LGD is usually defined as the ratio of losses to exposure at default (EAD). There are
broadly three ways of measuring LGD:
i.
Market LGD, which is based on the observed prices from the market soon after the
time where the actual default event occurs. This is the market price of the goods in
Murabaha Contract, the market rental in the Ijarah contract, the commodity or asset
price in the Salam and Istisna contracts
ii.
Workout LGD, which is based on the estimated cash flows, result from the contracts
that default considering the timing of event. This is the expected cash flow from the
payment in the Murabaha contracts, from the renter in the Ijarah contract, from the
sales of the commodities or assets in the Salam and Istisna contracts and from the
profits in the Musharakah and Mudarabah contracts.
iii.
Implied LGD, which is an entirely different approach to obtain on estimate of LGD. It
considers the “Credit Spreads “of the non-defaulted, but however risky, cases in
Islamic Contracts that may result in defaulted events.
The estimation of the LGD is difficult due to:
i.
The availability, of quality data for defining the default, assessing the recovery from the
collaterals, and estimating the cost resulting from the defaults;
ii.
The different priorities of payments in relation to other payments the obligor is past
due;
iii.
The legal regime declares itself bankrupt may differ from country to country;
iv.
The legal regime for collections before or after the obligor declares itself bankrupt may
differ from time to time throughout the collection period;
v.
The uncertainty of the duration of cash payments made by the obligor;
vi.
The continuous changes in the market values of the assets.
Exposure at Default (EAD): EAD is the estimation of the institution’s exposure in the event
of, and at the time of, counterparty, defaults. Based on Basel Credit Risk Model, the potential
exposure, in currency, is measured for the period of 1 year or until the maturity date, whichever
comes first. Under Basel II, a bank must provide an estimate of the exposure at Default (EAD),
in a banks internal system. All these loss estimates should seek to fully capture the risks of an
underlying exposure.
Market Risk Measurement
Market Risk: Market risk is the risk 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 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.
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The four types of risks that expose financial institutions to market risk are:
Rate of return (mark-up) or benchmark rate risks related to market inflation and interest rate;
Commodity price risks because, unlike conventional banks, they typically carry inventory
items (predefined prices);
FX rate risks in the same way as conventional banks;
Equity price risks, mainly in regards to the equity financing through the PLS modes.
- Rate of return risk:
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Murabaha financial contracts – repayment of installment (include price of commodity together
with institutions ‘profit’);
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Ijarah leasing contracts – corresponds to actual market price;
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Salam and istisna contracts – price of commodity in respect to the future delivery date, based
on the estimated benchmark rates.
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Islamic financial contracts that have fixed income assets driven by rate of returns cannot be
adjusted in regards to changes in the benchmark market rates; as a result, financial institution
that provide such contracts are facing risks arising from the movements in the market interest
and inflation rates.

Market yield curves: The market yield curve provides information about the market future
expectations illustrated on a graphical representation of the yields for a range terms to maturity.
The yield curves are considered to be a predictor of future economic activities and may provide
signals of pending changes in economic fundamentals.
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Types of yield curves: There are mainly four types of yield curves that can be used to define
market behaviors and are driving the market parameters of Islamic financial contracts;
The Normal yield curves: where the curve rises as the maturity lengthens, is increasing
positively. This curve reflects an expectation for the economy to grow smoothly in the future.
The Steep yield curves: where the curve rises steeply, represents the behavior of an economy
that is expected to improve quickly in the future. Istisna contracts
The Flat and Humped yield curves: where the former one maps an uncertainty in the
economy.
The Inverted yield curve: that occurs when long-term yields fall below short-term yields.
Murabaha & Ijarah contracts: upward sloping asymptotically with a positive slope;
Financial institutions and investors that are dealing with Islamic financial contracts and agreements
may combine different types of yield curves by considering the expected economic and market
conditions.
- Commodity risk:
Drivers of the Commodity Risk:
Price Risk: Commodity price risk affects consumers and end-users such as manufacturers,
governments, processors and wholesalers; it also affect commodity producers; it influences production
and business revenues and thus the decision making; there are several factors that affect the price of the
commodities and this includes:
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Expected level of inflation;
Exchange rates;
General economic conditions;
Cost of production;
Ability to deliver on time;
Availability of substitutes;
Weather conditions;
Political stability
Cost Risk: The cost of manufacturing the commodity is an additional input risk that should also be
considered; in Istisna contracts, the manufacturing or construction of assets are directly affected by the
cost of raw materials and other production costs;
Market’s Influence Rate Risk: Market’s influence is directly influenced by the commodity price
where they need to be harmonized in proportion to this rate; in the case of Murabaha – price of the
commodity at the maturity date of the repayments; in Salam and Istisna contracts, bank are exposed to
market influence rate since the commodities are purchased in advance;
FX Rate Risk: In the case of Istisna and Salam contracts, the bank may agree to purchase a
commodity from the domestic market and make an agreement on selling it to a foreign market; in this
case , the trade uses more than one currency and thus is exposed to FX rate risk;
Quantity and Time Risk: This is related to the capability of the manufacturer to produce the planned
amount of commodities at a specified period. Istisna contracts may expose the bank to a high degree to
this type of risks. On the other hand, the market demand for the commodity on different time periods
may influence the quantity that should be produced;
Future Delivery Risk: The Salam contract agreement allows the purchaser to lock in a price, thus
protecting the purchaser from price fluctuation. However, the price of the commodity at the delivery
time may be different from the market price and thus the financial institution is exposed to commodity
price risk. In istisna sale, the price is paid in advance at the time of the contract and the object of sale is
manufactured and delivered later. However, any failure from the seller to deliver on time may cause
commodity risk with significant losses;
Inverted Price Risk: There are occasions when the market is following specific commodity price
structures. This may appear when the demand for cash, by the seller, or near-term delivery, by the
purchaser, of a commodity exceeds supply, or even when there are supply problems; then an invert or
backwardation market may result. Such types of commodity risks affect both the Salam and Istisna
contract agreements.
Equity Price Risk: Equity price risk in regards to Islamic financial contracts is the risk that the
financial institution is exposed by its investments’ depreciation as a result of business or market
dynamics that are causing losses. The Mudharabah and Musharakah contracts may result in equity
price risks.
QUANTIFICATION OF FX RISK, EQUITY RISK AND COMMODITY RISK
The quantification analysis and valuation of rate of return risk must consider a higher number of market
factors and are modeled by future yield curves;
For FX risks, every percentage of change in FX rates affects the price of the position with the same
percentage. Thus, their evaluation is rather simply applied for generic cases where most of the Islamic
financial contracts are classified;
The equity price may be fixed in Diminishing Musharakah contracts, however, any last equity price
and exit of the partnership is based on the market price of the equity; Equity appear to have quite
smooth distributions of returns and they can efficiently substitute for any valuation models.
The quantification of the commodity risk which is arising from the movements of the commodity’s
prices should be based on these prices. The behavior of the commodity price risk can be very similar to
that of equities, especially in the case of specific risks.
DATA REFERRING TO MARKET RISK FACTORS
Islamic financial products carry more than one market risk factor; moreover even a simple portfolio
usually contains different types of contracts. This combination of risk factors and contracts increases
the complexity of collecting and combining the information needed for market risk analysis. Most of
the movements can be easily picked up from organized exchanges; however, several risk factors
cannot be directly observed in the market place and should be calculated by using other sources of
information.
Market data such as prices referring to Islamic products and agreements are exchanged directly or
indirectly at regular points in time. In the Islamic financial contracts, the different points in time that
are mainly considered for trading market data used during market risk analysis are the ones that refer to
the contracts’ agreement date and the delivery dates.
In general, the more complex the synthesis of the portfolio or balance sheet accounts constructed by
Islamic products, the higher the number of risk factors involved and the higher the amount of data
needed from the associated databases. It is important to highlight that the trading processes during the
lifetime of Islamic financial products is less dynamic than conventional financial products.
There are many problems arising during this data extracting process; financial institutions are mainly
using the ETL systems that are transferring the information from the core database to the risk
management system. Errors in information data may result in an under-or-over-estimation of the
volatility and thus will affect the measurement of the Value at Risk (VaR)
SENSITIVITY IN MARKET RISK
Sensitivity is a significant factor that plays a critical role in the market risk analysis. Sensitivity to
market risk in Islamic products reflects the relationship between the cause from a financial risk factor
and its adverse impact to the financial institution’s earnings from these contracts. The causes are
initiated from the volatility in risk factors arising in Islamic financial contracts.
In market risk analysis, the volatility of the risk factors is transformed into market risk by either linear
or non-linear means that is encompassed into a unique measure, called market sensitivity. Thus, every
change in risk factors has an equal quantitative percentage effect on the total position invested in the
product.
Thus, integrating the sensitivity and volatility factors, therefore,
Market Risk = (Sensitivity) x (Volatility)
MARKET RISK VALUATION MODELS
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There are two types of analysis for evaluating the market risk.
i.
Static analysis
ii.
Dynamic analysis
Using the static analysis , no change in positions related to financial contract is taken into account;
however, the only element that might vary is the market conditions;
The dynamic analysis is a forward-looking analysis based on defined market price scenarios, business
strategies and customer behaviors. The market positions are moving over time and the prices are
always influenced by the customers’ behavior. Market prices are driven by the rules of the market and
such rules have to be considered in financial risk analysis. Dynamic analysis is a strong tool for
planning the future business in regards to what and how the bank should provide its Islamic financial
contracts so that they can be profitable to the institution and beneficial to its clients.
Both static and dynamic simulation plays a key role in risk management and institutions must be able
to perform both types of analysis.
In VaR model analysis, both the position data and the market data are used and the figure below shows
the process flow of market and position data for implementing the VaR approach that finally results in
the risk evaluation analysis reports.
Having both position and market data, every VaR mechanism, implicitly or explicitly, is driven by the
selection or estimation of the components as shown below and includes the assumptions for the data
distribution, the window length of the data used for parameter estimates, the confidence level, the
holding period that defines the time horizon for holding the investment, and the individual volatilities
and co-movements between or among risk factors defined by using return time series.
For the implementation of the VaR model, there are two classes of data that should be carefully used
and assessed: position data and market. Position data is defined within the systems that map the
performance of contracts in the institution’s accounts or portfolio. However, market data is usually
done by using either interpolation techniques or extensive methods.
The following are the various interpolation techniques that can be used:
i.
Linear interpolation;
ii.
Exponential interpolation;
iii.
Cubic spline interpolation;
Each of the interpolation techniques can be applied according to the data availability, and the level of
approximation.
In the VaR analysis, there is a strong assumption that the synthesis of the portfolio remains unchanged
throughout the holding period. Thus, in the construction of the portfolio, risk managers must be aware
that, during their VaR analysis, the portfolio should remain steady.
Under the above assumption, the set of market risk factors remains the only source of risk. Thus,
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The market factors that drive the value of commodities in the Murabaha, Salam and Istisna
contracts are commodity prices;
The main factors that drive the FX in all Islamic financial products are the FX rates;
The factors that drive the equities in the Musharakah and Mudarabah contracts are the
equity prices;
The factors that drive the rate of returns in the Murabaha, Ijarah, salam and Istisna financial
contracts are the yield curves.
The three alternative quantitative evaluation methods are:
i.
The Variance-Covariance approach (VC);
ii.
The Monte Carlo approach (MC);
iii.
The Historical-Simulation approach (HS);
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These three approaches can be used to quantify Islamic financial products by deriving the
distribution of the changes caused in the value of a portfolio at the end of the holding period. In
most cases, in market risk analysis, this distribution appears to be nearly symmetric and is often
approximated as normal which may allow for analytical solutions to be developed.
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The variance – covariance method is applied when there is the assumption that the risk factors
follow a multivariate normal distribution and they exhibit serial independence. This method is
suitable for Musharakah and Mudarabah contracts where there are cash earnings/profits; this
method could be in Murabaha and Ijarah contracts where the market values may vary from the
actual payment installments.
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The key parameter for VaR estimation under variance – covariance method is the measure of
volatility. Note that, in order for the volatility to be estimated, it is essential to determine the
time series of the prices on returns for each of the contracts that are under consideration. The
concept of volatility is approximated by the variance or standard deviations of returns.
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The Monte Carlo simulation is applied when, on a portfolio, the risk factors have a high degree
of non-linearity. Based on different mathematical approaches, the changes in risk factors can
be simulated.
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The Monte Carlo simulation is far the most powerful method to compute VaR and is able to
account for wide range of exposures and risks, including non-linear price risk, volatility risk
and even model risk.
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The historical simulation method provides a straightforward implementation of full valuation.
The underlying methodology consists of going back in time and applying current weights to
time series of historical asset returns involved in the computation of VaR.
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The main characteristics of the historical simulation method are that it is the most cost-effective
and least consuming approach in terms of computational needs. This method is relatively
simple to implement as long as there is availability of historical data represented mainly in time
series.
Measurement of Operational Risk
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 includes 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.
The Basic Indicator Approach (BIA): This approach uses a gross income as a proxy measure of
exposure to operational risk. Hence, it requires banks to hold capital for operational risk equal to the
average over the previous three years of a fixed percentage of positive gross income. Years in which
gross income is negative are ignored. The proposed percentage is 15%.
The Standardized Approach (SA): This is a refinement of the BIA in which banks activities (and
gross income) are divided into eight lines of business, and the total capital charge is calculated as the
three year average of the simple addition of the capital charges across the eight business lines in each
year. A negative capital charge in any one year for one LOB is offset against the positive capital
charges for the other LOBs in that year, unless the total for the year is negative, in which case the input
for the year to the three-year calculation is zero. The percentage for the different LOBs varies from
18% for corporate finance, trading and sales, and payment and settlement, through 15% for commercial
banking and agency services, to 12% for retail banking, asset management, and retail brokerage.
Advanced Measurement Approaches (AMA): These approaches, use of which is subject to
supervisory approval, allow banks to develop their own proxy measures of operational risk exposure.
Key risk indicators are being used increasingly by many institutions, often as a top-down method of
identifying trouble spots in the organization. The approach tries to use both qualitative and quantitative
factors in a predictive rather than a causal way. Indicators can be identified at the LOB level. They can
include such measures as transaction volumes, portfolio size, staff numbers, and IT budgets. These
factors are tracked overtime and regressed against loss data.
Key to any methodology used in measuring operational risk is the data collection process. Some of the
questions that need to be asked are: what cut-off should be employed, what causal data are needed,
what to do when there is overlap with credit or market risk, should near miss incidents be recorded, and
how to define near miss. Are indirect losses also monitored, and what incidents that in fact lead to
direct or indirect gains.
Operational risks faced by Islamic banks can be divided into three categories:
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Operational risks that are consequential upon various kinds of banking activities, and which
are somewhat similar for all financial intermediaries. However, the asset-based nature of
financing products may give rise to forms of operational risk in contract drafting and
execution.
Shariah compliance risk that is: risks relating to potential non-compliance with Shari’ah
rules and principles in the bank’s operations and the further risk associated with the Islamic
bank’s fiduciary responsibilities as Mudarib towards fund providers under the Mudarabah
form of contract, according to which in case of misconduct or negligence by the Mudarib
the funds invested become a liability of the Mudarib.
Legal risks arising either from the Islamic bank’s operations or problems of legal
uncertainty in interpreting and enforcing Shari’ah contracts.
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 Basel Committee on Bank Supervision has identified seven categories of operational risk :
i.
Internal fraud;
ii.
External fraud;
iii.
Employment practices and workplace safety;
iv.
Clients, products and business practices;
v.
Damage to physical assets;
vi.
Business disruption and system failure;
vii.
Execution, delivery and process management
- Banks must assess their exposure to each type of risk for each of the eight business lines namely:
Corporate finance, trading and sales, retail banking, commercial banking, payment and settlement,
agency services, asset management, retail brokerage
- Severe but not catastrophic losses: Unexpected severe operational failures should be covered by an
appropriate allocation of operational risk capital. Those losses are covered by measurement processes
described later.
- Catastrophic losses: These are the most extreme but also the rarest operational risk events – the kind
that can destroy the financial institution or bank entirely. VaR and RAROC models are not meant to
capture catastrophic risk, since they consider potential losses only up to a certain confidence level (say
1%), and catastrophic risks are by their very nature extremely rare. Banks for instance, may tighten
procedures to protect themselves against catastrophic events, or use insurance to hedge catastrophic
risk. But the risk capital cannot protect a bank/financial institution against these risks.
- The firms’ activities should be divided into lines of business (LOB), with each business being
assigned an exposure indicator (EI). The primary foundation for this analysis is the historical
experience of operation losses. Where no loss data, inputs have to be based on judgment and scenario
analysis
- For example, a measure of EI for legal liability related to client exposure could be the number of
clients multiplied by the average balance per client. The associated probability of an operational risk
event (PE) would then be equal to the number of lawsuits divided by the number of clients. The loss
given an event (LGE) would equal average loss divided by the average balance per client.
- A measure of EI for employee liability could be the number of employees multiplied by the average
compensation. The PE of the employee liability would then be the number of lawsuits divided by the
number of employees, and the LGE would be the average loss divided by the average employee
compensation.
- A measure of EI for regulatory, compliance and taxation penalties could be the number of accounts
multiplied by the balance per account. The PE would then be the number of penalties (including cost to
comply) divided by the number of accounts, and the LGE would be the average balance per account.
- A measure of EI loss of or damage to assets could be the number of physical assets multiplied by their
average value. The associated PE would be the number of damage incidents divided by the number of
physical assets; the LGE would be the average loss divided by the average value of physical assets.
- The measure of EI for client restitution could be the number of accounts multiplied by the average
balance per account. The PE would then be the number of restitutions divided by the number of
accounts, and the LGE would be the average restitution divided by the average balance per account.
- A measure of EI for theft, fraud and unauthorized activities could be the number of accounts
multiplied by the balance per account (of the number of transactions multiplied by the average value
per transaction). The corresponding measure for PE would be the number of frauds divided by the
number of transactions. The respective LGEs would be the average loss divided by the average
balance per account or the average loss divided by the average value per transaction.
- A measure of EI for transaction-processing risk could be the number of transactions multiplied by the
average value per transaction. The PE would then be the number of errors divided by the number of
transactions. The LGE would be the average loss divided by the average value per transaction.
- There are two distributions that are important in estimating potential Operational risk losses. One is
the loss frequency distribution and the other is the severity distribution. The loss frequency distribution
is the distribution of the number of losses observed during the time horizon (usually a year). The Loss
severity distribution is the distribution of the size of the loss given that a loss Occurs. It is usually
assumed that loss severity and loss frequency are independent.
- The loss frequency distribution must be combined to the loss severity distribution for each loss type
and business line to determine a total loss distribution. Monte Carlo simulation can be used for this
purpose.
- In any bank activity, they are likely to be the number of identifiable factors that tend to drive
operational risk exposure and that are also relatively easy to track. For example, in the case of system
risk, these key risk drivers (KRDs) might include the age of computer systems, the percentage of
downtime as a result of system Failure. Ideally, KRDs would be entirely objective measures of some
risk-related factor in a bank activity.
- Although KRDs are not a direct measure of operational risk, they are a kind of proxy for it. KRDs
can be used to monitor changes in operational risk for each business and for each loss type, providing
red flags that alert management of a rise In the likelihood of an operational risk event. Unwelcome
changes in KRDs can be used to prompt remedial management action.
Risk Management Information Systems:
They are typically computerized systems that assist in consolidating property values, claims, policy,
and exposure information and provide the tracking and management reporting capabilities to enable
you to monitor and control your overall cost of risk.
Risk management information systems (RMIS) are used to support expert advice and cost-effective
information management solutions around key processes such as:
 Risk Identification & Assessment
 Risk Control
 Risk Mitigation
 Risk Financing
To allocate resources and implementing cost-effective controls, organization after identifying all
possible controls and evaluating their possibility and effectiveness, should conduct a cost-benefit
analysis for each proposed control to determine which controls are required and appropriate for their
circumstances
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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 subsystems such as:
• Risk Management Policy Manual;
• Risk Management Record Systems;
• Risk Management Information Systems;
• Internal Communication System.
Currently, most managers want four things from their risk management information system:
1. Calculate Value at Risk;
2. Perform scenario analyses;
3. Measure current and future exposure to each counterparty;
4. Do all three of the above at varying levels of aggregation, across various groupings of risks, across
product types, and across subsets of counterparties.
The role of information in risk management:
It would be impossible to monitor, measure, manage and mitigate the risk without sufficient,
timely and accurate information. The monitoring of the cash flows and the calculation of credit
risk, market risk, and operational risk depends on the appropriate information systems and
availability of information. Thus, information collection, processing, and preserving plays an
important role in all stages of risk management. Information is generated at all stages of activites
in a financial institution and collecting it at the point of origin will ensure accuracy and
reliability.
Strategic Risk: Risk associated with the firm’s future business plans and strategies, and its long-term
survival of business and building additional sustainable value into the business.
Types of strategic risk:
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Plans for entering new business lines
Expanding existing services through mergers and acquisitions
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Enhancing infrastructure (e.g., physical plant and equipment and information technology and
networking).
New technologies that can render your products obsolete
Sudden shifts in customer tastes that could redefine your industry
How to mitigate strategic risk:
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Hard work from both top management & the board
A thorough strategic planning process is a MUST
Powerful countermeasures for each risk
A highly efficient integrated strategic risk process must be in placed
Simple 4 steps plan:
Change the language throughout the organization
Develop systems for the siloed risk analysis to be shared across the group
Synthesize the risks, articulate the necessary innovation & develop a strategic way forward
Engage the board in a yearly strategic workshop
Benefits of mitigating strategic risk:
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Protect company stability
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Develops tools & systems for systematically identify the opportunities
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Turns strategic threats into growth opportunities
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Increase the Risk-Adjusted Return & Capital of the firm (RAROC)
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Corporate reputation is protected