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Page 1

Risk Management Issues

in Islamic Banking
Cairo – January 24th 2009
Ken Dorph
Page 2

Contents
• Professional Background
• Overview
• Islamic banking products
• Treasury risks
• Operational risk
• Shari’a risks
• Capital and pricing
Page 3

Professional
Background
Page 4
• Wharton MBA in International Finance, following MA in
Middle East
Studies
• Early career with Citibank (Europe / Egypt), Smith
Barney (Saudi
Arabia / the Gulf) and World Bank / IFC (Europe / Middle
East)
• Consulting globally in Financial Institutions since 1990
with
Booz•Allen, KPMG, IFC, BearingPoint - in Asia, USA,
Latin America,
Middle East and Europe
Ken Dorph
Page 5

Ken Dorph
‫ﺔﯿﺑرﻌﻠا ﺔﻐﻟﻟاﺑ‬
-
‫دﺣ ﯽﻟا‬
‫!ﺎﻤ‬
Special expertise in Middle East …
Page 6
• Corporate and consumer strategies, and risk policies
for
leading Islamic bank
• Strategy for new shari’a-compliant home finance
company
• Strategy for three new Islamic investment companies
• Shari’a Board charter for new Islamic investment
company
• SAMA audit of corporate strategy and risk of leading
banks
• Credit risk system for conventional bank with Islamic
products
• Saudi capital market study
• Core system for real estate bank transforming to
Islamic
Recent projects (mainly Saudi & GCC)
Ken Dorph
… including in Islamic finance
Page 7

In the following pages, we’ll look at examples

of
some different risks faced by Islamic banks
• Impacts of shari’a compliance on credit, market,
and
operational risk
• Not exhaustive list of all unique Islamic risks
• Based mainly on observations in Saudi Arabia
and
GCC
Page 8

Overview
Page 9

Islamic law – shari’a – has several clear

proscriptions on financial activity
• The requirement to pay zakat
• Prohibitions on financing prohibited activity,
such
as alcohol or prostitution
• Prohibition of:
– Qimar (gambling)
– Myisur (deceptive gaming)
– Gharar, or speculative outcomes
– Riba, usually translated as interest
Page 10

Riba implies unfairly getting a return on

funds
without sharing in the risk
• Riba comes from the root for ‘increase’ or ‘grow’
–
meaning increase in money value in and of itself
• Early Muslim scholars considered money a
symbol of
value but not a store of value in itself
• An increase in money without an underlying
increase
in the value of the symbolic good was unfair
Page 11

To most observers, riba sounds like interest

on debt
• A few scholars believe that riba means usury, i.e.
inequitable interest rates
• The great majority of scholars define riba more
closely
to interest – rent on money
• Concept of risk sharing – i.e. if enterprise loses
money,
unfair to expect the same back
• Seems to rule out classic deposit-taking and
lending
institution
• At first glance, seems classic division between
debt and
equity, but in fact more complicated
Page 12

Commercial and investment banks are

separated by
the difference between debt and equity
• I give you a loan of 100
• I expect 100 back, no matter
what
• I am willing to accept a
lower (but sure) return in
exchange for my
expectation
• I give you equity of 100
• I share in your ownership
• I expect to participate in the ups
and downs of your enterprise
• But I have a much greater
(unsure) upside potential to
compensate me for my risk-
taking
Commercial Banking Intermediary
Investment Banking Intermediary
Lend
Lend
Invest
Invest
Page 13
Conventional banks must return deposits “as
is” –
so have deep risk challenges with their assets
Loans
Other Assets
Deposits
Borrowings
Capital
Recompense from
interest differential
On balance sheet
assets and liabilities
Commercial Bank
Page 14

Investment banks, however, are a “pass

through” –
placing funds but not guaranteeing the risk
Investments
Investment
Pools
Specific
Investors
Recompense
from fees
Assets
Liab.
Capital
Investment Bank
Page 15

Most governments distinguish between

deposit-
taking banks and investment companies
• Until recently, the Glass-Steagall Act segregated
US
commercial banks from investment banks
• In most countries, including Saudi Arabia,
separate
agencies regulate each – conventional or Islamic
Central Bank / Banking
Supervisory Authority
Capital Markets
Authority / SEC
• On-balance sheet
“deposits”
• Low-risk asset pool
• Off-balance sheet
investments
• Customized assets
and asset pools
SWICORP

Page 16

We all know there is not a hard line between

debt
risk and equity risk
• The two are increasingly blended and
interdependent
• Low risk equity may be safer than high risk debt
Risk
Return
Treasury Bonds
First Mortgage Bonds
2nd Mortgage Bonds
Subordinated Debentures
Income Bonds
Preferred Stock
Conv. Preferred
Common Stock
AA
A
BBB
B
B
B
CCC
AAA
“Risk Free Rate”

• But contractually they differ – and deposits above

all
are seen as different
Page 17

Governments are universally keen to protect

depositors
• When deposit-taking banks fail, especially
systemically,
governments typically protect depositors
• The Basel accords (I and II) evolved to agree on a
global
approach to assigning bank capital to risk
Page 18

A world of risk management and capital

adequacy
has evolved to preserve depositors’ money
Risk Management
Expected
loss
Probability
of default
Loss given
default
Exposure at
default
=
x
x
Market
Credit
Operational
VaR
UL
AA AAA
.003 .001
BBB A
.03 .01
Solvency
Standard
Required Capital
Total “Economic” Capital = Reserves + Equity
Uncovered
Risk
Amount of
Loss
Probability
of Loss
Mean “expected” Loss
Unexpected Loss
(Standard Deviation)

Page 19

Islamic banks typically have on-balance

mudaraba
pools, along with qard hassan (no fee) deposits
Deposits or
investments?
Assets
Other Assets
Mudaraba
investment
pool (PLS)
Other Liab.
Capital
No fee
deposits
• Legally no commitment
to repay in full
• Profit rate cannot be
guaranteed in advance
• Widely perceived to be
low or no risk principal
• Profit rate closely follows
prevailing interest rates
However
Page 20

Implication: The more mudaraba liabilities

resemble
deposits, the more assets must limit equity-
type risk
Assets
Other Assets
Mudaraba
investment
pool (PLS)
Other Liab.
Capital
No fee
deposits
Bank-like
credit products
Page 21

Since most of the banks’ assets are effectively

credit products, they can default
• Credit risk management is essentially rooted in
the
same analysis as conventional credits
Probability
of default
Loss given
default
x
x
Exposure at
default
Rules-Based
Rating
Internal
Rating Based
Model
Empirical
Scorecard
Unexpected
Loss
Estimation
Historical
Default/
Recovery
Volatility or
Scenario
Analysis
Credit
Value-at-
Risk
Historical
Default
Database
Historical
Recovery
Database
Probability of
Default
Estimation
Loss Given
Default
Estimation
Expected
Loss
Estimation
Expected
loss
=
Page 22

In the following pages, we’ll look at a few

bank
credit products, as well as some broader risk
issues
Page 23

Islamic banking
products
Page 24

The classic murabaha is closest to the risk

profile of
a standard bank credit
▪ Client specifies goods to be purchased, e.g. raw material
or
capital goods. Contracts with Bank to acquire on client
account.
▪ Bank buys goods and acquires title of ownership from
seller.
Title transfer
Financing
agreement
Pays sales price plus
mark-up
▪ Client takes delivery. Client contracts to pay on deferred
basis.
Pays sales price
Construction equipment
Title transfer

‫ﺔﺤﺑاﺮﻤﻟا‬
Seller
Bank
Customer
Page 25

Murabaha of some kind represent the vast

majority
of credits in Saudi Arabia and the GCC
• May be over 90% of assets in some banks
• Very high in consumer lending, with most credits
guaranteed by garnished salaries
• Believed to be over 80% of total system Islamic
credits
• Remainder mainly ijara (e.g. cars) in consumer
and
musharaka in corporate
• Not often widely touted, since many feel this is not
the
most ideal Islamic investment
Page 26
Economically, a murabaha is very similar to
an
installment credit
However there are several key differences…
Principal
Outstanding
Payments
0
Time
5
2
3
1
4
Page 27

Most important, the bank must own the asset,

even
if momentarily
• If ownership does not pass through the bank,
becomes a cash loan – and so haram
• The degree of proof of ownership differs by
Shari’a
Board, and so with it the risk
Liberal
Conservative
May have
back to back
agreements
May have pre-
agreed buy back
agreement
May be verbal
contracts
Must be “open”
possession
Must be written
contracts
Greater risk (credit, operational, market)
Page 28

Payments may not include interest, however

finance
charges may be included in the installments
• Not charged separately (as is interest) but as part
of
total fees
• May reflect prevailing interest rates, as a market
reference
Page 29

If a murabaha defaults, the Bank cannot

compensate itself by running penalty charges
• Otherwise it would be riba
• Shari’a Boards feel differently about levying a
one-
time late fee
Liberal
Conservative
May charge
and post to
profits
May charge but
give to charity
May not charge
on principal
Greater risk
Page 30
In Saudi Arabia and the GCC, a large share
of
transactions are commodity murabaha
• Back-to-back commodity trade which effectively
permits
a cash deposit or a cash credit
• For foreign currency, typically on London
Commodity
Exchange (copper, palladium, etc.)
• For domestic currency, may be with local broker
(e.g.
rice, coffee)
• Interbank placements are usually commodity
murabaha
• Most consumer credits and many corporate
credits are
structured in this way
Page 31
Broker A
Bank (agent)
Broker B
As a placement, the commodity murabaha
acts as a
cash time deposit
Funds
Commodity
(e.g. copper)
2
Sells copper on
deferred basis
Islamic bank
3
Repays $110 at
maturity, less fees
1
Pays Bank as agent $100 to
buy copper spot
1
Page 32

On the other side, a reverse murabaha – or

tawarruq
– may act as a cash credit
Funds
Commodity
(e.g. copper)
Broker B
Bank (agent)
Customer
Sells copper and
receives $100 in cash
2
3
Repays $110 at
maturity, less fees
1
Bank buys $100 of
copper for client
Page 33

The direct credit risk of a tawarruq is similar

to a
conventional cash credit, but with some
added risks
• The extra group of contracts adds operational
risk,
which may lead to other risks
– Market risk (e.g. settlement risk)
– Credit risk (e.g. counterparty risk)
• Again, the degree and timing of ownership
required
changes the risk
• Similar to simple murabaha, penalty charges may
not
be added
Page 34

Ijara are leases and their risks are

comparable to
conventional leases
• Bank owns asset, with all that implies
• Often must be in separate leasing company
• If leased to purchase, economically very similar to
a
conventional credit
• Financial charges may be built into rental fees
• Mainly used for cars, but some attempt to set up
ijara to buy homes
• May be set up to be variable rate – re-priced
against
a reference rate
• Less popular among corporates, due to zakat
disadvantages
 Page 35

Musharaka – or partnership – is often viewed

as an
‘ideal’ Islamic investment
Proportional
contracted return
Y%
X%
Oil rig
‫ﺔﻛرﺎﺸﻤﻟا‬
Bank
Musharaka
joint venture
Customer
Page 36

Classic musharaka resembles a pure equity

investment, but may be structured to limit
equity risk
• Contracts may be added to ring fence open-ended
equity risks
• May be blended with other contracts, such as
ijara,
to further define risks
Page 37

Some banks use musharaka, for example, for

post-
import financing
90%
10%
Customer
Bank
Musharaka
joint venture
$100k worth
of coffee
1. Bank purchases good
2. Enter into ijara contract
to use good for a year
3. Agree to purchase at end
of year, either cash or
same value worth of
good
Musharaka
agreement
Ijara
agreement
Repurchase
agreement

Page 38

Treasury risks
Page 39

Treasury and, more broadly, market risk

management is complicated by shari’a
compliance
• Most derivative contracts typically not permitted
– Swaps (e.g. foreign exchange)
– Options
• Some synthetic products have been created and
are
being tested in more liberal regimes
• Strong need for shari’a compliant instruments to
manage liquidity:
– Short-term placements and borrowings
– Government and investment grade sukuk
• The more that liabilities are viewed as deposits,
the
more the bank must have active ALM
Page 40

The existence of a “profit rate gap” depends

on how
liabilities are viewed
Assets
Other Assets
Mudaraba
investment
pool
Other Liab.
Capital
No fee
deposits
If profit rate is perceived
as expected, the bank has
a gap to manage
Page 41
124.9
Total liabilities and equity
23.6
Total equity
101.3
Total liabilities
11.6
Other liabilities
8%
8.5
Time deposits
80%
81.2
Demand deposits
124.9
Total Assets
104.9
Total Investments
0.6
Other
4.1
Murabaha
1.6
Istisnaa
53%
56.0
Installment Sale
41%
42.6
Mutajara
10.3
Other assets
9.7
Due from SAMA

The proportion of demand deposits, of

course,
changes the risk
Example: Al Rajhi 2008
Commodity murabaha
Consumer installment murabaha
Qard hassan
Mudaraba
Page 42

Operational risk
management
Page 43

All things being equal, Islamic banks may

have
higher operational risk
• Greater number of contracts
• Newer supporting systems
• Evolving skill sets
• Lack of consistency on best practice
 Page 44

Operational risk management is similar, but

may be
hobbled by insurance options
• Operational risk
policies
• Key risk indicators
• Risk mapping
Measure
Mitigate
• Event database
• Self-Assessment
• Operational risk
quantification
(PE, LGE)
Identify
• Funded retention
• Loss allocation
• Internal control
• Risk financing
• Insurance
Acceptable takaful
coverage?
Page 45

Shari’a risk
Page 46

Shari’a risk itself is a key risk that must be

managed
• Reputational risk – perception of shari’a
compliance
– Of bank as a whole
– Of specific products (e.g. salability of tainted
sukuk)
• Enforcement risk
– In case where compliance disputed
– Multiple contracts
– Lack of single agreed ruling
– Lack of jurisdiction
Page 47

Shari’a governance is an evolving challenge

How many Board members?
What voting and approval process?
Reputation? Financial knowledge?
Shari’a disclosure?
What degree of compliance?
Conflicts of interest?
Page 48
The lack of consensus on shari’a interpretation
adds a
considerable risk element
Liberal
Conservative
• Telecom minutes are
financeable asset
• Tawarruq may close out
equity risk
• Market price of final
sukuk may be fixed
Yes
No
Greater risk
News & Features
SEARCH

Booming Islamic bond market

embroiled in debate over
religious compliance
The Associated Press
Published: January 11, 2008
Sukuk market in compliance row
Published Date: January 12, 2008
MANAMA: The booming market for
financial products that comply with Islamic
law was thrown for a loop recently by
criticism from a leading scholar, who has
set off a debate about whether the industry
has sacrificed religious principles for the
sake of growth at a time of surging Mideast
oil revenue. Shari'ah, or Islamic law,
prohibits charging or paying interest, so
bankers and lawyers have developed a
rapidly growing financial market by
restructuring conventional products like
bonds to make them compliant with Islam.
Sheikh Mohammed Taqi Usmani

Page 49

Capital and pricing

Page 50
A final question is how well Islamic banks measure
and
price their risk and allocate capital
• How well do any banks in the region price their
risk?
• How well does risk measurement and capital
allocation capture shari’a differences?
• Does Basel II in any case really capture risk?
Shari’a compliant banks and products do not
necessarily
have higher risk, but some of their risks do differ