Risks and Risk Management in Islamic Banks

A Rating Agency Perspective

Elisabeth Jackson-Moore

Managing Director

= High growth of Islamic finance

= Failure to commoditise Islamic products

= Operational risk as a result of type of product and demands of Shari’a boards

= Lack of hedging products

= Limited adoption of AAOIFI standards - not only accounting but also governance and Shari’a standards

= Lack of suitable prudential regulations in many markets

= Failure to develop products for liquidity management

= Various estimates suggest that Islamic finance has been growing at upwards of 10% per annum for the last decade

= Deposits are growing faster than assets due to a lack of suitable products

= Few “standard” products - morabaha comes closest, but even here there are many variations

= As a result:

= Documentation takes longer to prepare, with risk of error

= Shari’a boards need to be consulted more often, which again takes time

= Hard for Islamic institutions to compete with the rest of the market

= Documentation more likely to contain errors as a result of lack of standardisation

= Innovative products more vulnerable to operational risk

= Shari’a board requirements impose a stricter discipline on procedures which, if not followed exactly, may lead to restrictions on income recognition

= Experience has shown that many losses experienced by Islamic banks can be attributed to inadequate or failed internal processes, people and systems or from external shocks - the Basel definition of operational risk

= Not easy for banks to hedge various risks, particularly foreign currency risk

= This either limits the products banks can offer or leads to significant open positions

= AAOIFI has done excellent work over the last decade in developing accounting standards more appropriate for Islamic banks than other standards

= However only a few banks currently use these standards and IAS has been interpreted in many different ways by different banks, leading to lack of transparency and lack of comparability

= AAOIFI has also produced governance standards for Shari’a boards. Adoption of these should lead to greater agreement on products and procedures

= Only very few examples of prudential regulations specifically for Islamic banks - such as BMA regulations

= Impossible for supervisors to adequately monitor business of Islamic institutions using standard returns

= for example, many practices have evolved where investors funds are moved from one investment fund to another, or to the parent, when there is excess liquidity or a need for liquidity

= Has always been our greatest concern

= More instruments for overnight liquidity are needed (to complement ABC CC)

= 7 or 8 day morabaha transactions are more readily available, but interbank is quite limited

= Very few instruments traded on any secondary market

= IIFM will endorse instruments, but in practice, banks must create them

= LMC is seeking to develop a market but faces big challenges and so far has made slow progress

= Although Islamic banks generally claim that they take fewer risks than conventional banks as transactions are backed by real assets, we believe that there are other, considerable risks in many areas

= The bodies established in the last few years have still to be accepted by the market and gain credibility

= The IFSB appears to hold most promise for the successful development of Islamic banking