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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: 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: 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: - - Orientation Analysis of Documents: • Analysis of Financial Statements • Flow charts of the operations • Organization Charts • Existing Policies • Loss Reports • Contracts & Leases • 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, • In Murabaha and Salam contracts – alongside the banks, both the seller and buyer are considered as counterparties; • In Ijarah contracts – the renter/lessees; • In Istisna’a contracts – the buyer, user contractor or manufacturer • In musharakah & mudarabah contracts – the business partners and agents; Financial institutions that provide Islamic financial products are also exposed to credit risk because of the emphasis on lending in the Murabaha, leasing in the Ijarah, promising to deliver or to buy in Istisna and Salam, and investing on business performance in the Musharakah and Mudarabah contracts. 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: - 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: • • • • 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; - 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. 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. 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). 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: The model result; The factors that might not be predicted; The correctness of the estimation of parameters; How close the model to reality - 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. 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. 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; 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. 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). 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 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. 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. 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. 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. 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. 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. 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. 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. 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. 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: Murabaha financial contracts – repayment of installment (include price of commodity together with institutions ‘profit’); Ijarah leasing contracts – corresponds to actual market price; Salam and istisna contracts – price of commodity in respect to the future delivery date, based on the estimated benchmark rates. 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. 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: 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 - 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, - 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); 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. 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. 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. 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. 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. 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. 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: - - - 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 - - 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: - Plans for entering new business lines Expanding existing services through mergers and acquisitions - 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: 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: - Protect company stability - Develops tools & systems for systematically identify the opportunities - Turns strategic threats into growth opportunities - Increase the Risk-Adjusted Return & Capital of the firm (RAROC) - Corporate reputation is protected