1. Fahad Zafar MBA (Bradford, UK),BSc (Middlesex, UK),Certificate: Islamic Banking (State Bank, Pakistan),Certificate: Risk Management (ESC Toulouse, France). Mayfair Business Consultants Lahore, Pakistan

2.

Risks are uncertain future events which could influence the achievement of the banks objectives:

• Strategic,

• Operational,

• Financial,

• Compliance.

3.

O my children, do not enter capital of Egypt by one gate but go into it by different gates. However know it well that I cannot ward off you Allahs will for none other than He has nay authority whatsoever. In Him I have put my trust and all who want to rely upon anyone should put their trust in Him alone.

• (Surah Yusuf: Verse 67)

4.

Prophet (PBUH) once asked a Bedouin who had left his camel untied, Why do you not tie your camel? The Bedouin answered, I put my trust in God.

Prophet (PBUH) then said, tie up your camel first then put your trust in God.

5. Shariah ComplianceIs the essence ofIslamic Finance Objective Fulfillment e.g. Promote justice, fairness & protection of human necessity (Shariah) Minimizing Risk e.g. Mitigate Shariah Non compliant risk at decision making level as well as operational level. Alternatives e.g. Alternative to Riba based activities. 6. Shariah Governance Shariah Committee Audit Committee Shariah Advisor AAOIFIGovernance Standards SBP Guidelines IFSB Standards 7.

Risk management is the process by which various risk exposures are:

• • Identified,

• • Measured/ assessed,

• • Mitigated and controlled,

• • Reported and monitored.

8.

• Strategic Level

• • Encompasses senior management and BOD

• Macro Level

• • Within a business area or across business lines

• Micro Level

• • On-the-line risk management.

9. BANK CAPITAL Depositors Counter-parties Linkages with other balance sheets Linkages with other balance sheets Contingent claims Funding side risks Asset side risks 10. ISLAMIC BANKS TRADITIONAL BANKS Tier 1 Capital (equity) Tier 1 Capital (equity) Tier 2 Capital (?) Tier 2 Capital (Subordinated loans) Current accounts Current accounts Saving accounts Interest-based Saving accounts Unrestricted Profit Sharing Investment Accounts (PSIAs) Time & certificates of deposits Profit equalization reserves (PER) ReservesInvestment risk reserve (IRR) 11. ISLAMIC BANK TRADITIONAL BANK Current accounts Current accounts Banks in both cases use shareholders equity to protect these deposits Profit sharing investment accounts (PSIA) Time deposits, certificates of deposits, etc fixed income liabilities

Shareholders equity protects these liabilitiesonly in case of fiduciary risks(theory);

• Profit Equalization Reserve (PER)

• Investment Risk Reserve (IRR)

Shareholders equity and subordinated loans protect these liabilities against all risks Cost of funds: Variable Cost of funds: Fixed 12. Uses of Funds ISLAMIC BANKS Cash & balances with other banks Sales Receivables(Murabaha, Salam, Istisnaa) Investment securities Musharakah financing Mudaraba financing Investment in real estate Investment in leased asset Inventories (including goods for Murabaha) TRADITIONALBANKS Cash & balances with other banks Loans Mortgages Financial leases Investment in real estate Securities 13.

• Board of Directors/ RMC

• State Bank

• Islamic Financial Service Board (IFSB)

• AAOIFI

• ICAP

14.

Risk Management

• Guidelines on Risk Management

• • BSD Circular #7, 15 thAug 2003.

• Guidelines on Internal CRR Systems

• • BSD Circular #8, 29 thOct 2007.

• Risk Management Guidelines for IBIs

• • IBD Circular #1, 2 ndJan 2008.

• ICAAP Guidelines

• • BSD Circular #17, 2008.

15.

Stress Testing

• Guidelines on Stress Testing

• • BSD Circular #5, 27th Oct 2005.

Internal Controls

• Guidelines on Internal Controls

• • BSD Circular #7, 27th May 2004.

• • BSD Circular #1, 14th Jan 2006.

• Policy Framework in Banks

• • BSD Circular #3, 2007.

16.

15 Guiding Principles, divided into:

• General(1 Principle)

• Credit risk(4 Principles)

• Equity investment risk (3 Principles)

• Market risk(1 Principle)

• Liquidity risk(2 Principles)

• Rate of return risk(2 Principles)

• Operational risk(2 Principles)

17.

These principles are not radically different from those applicable to conventional banks.

Fundamental differences:

• Emphasis on Shariah compliance.

• 6 out of 15 principles make explicit reference to Shariah rules.

18.

• Review of policy & procedures.

• Designing of scoring models.

• Post facto review/ analysis.

• Risk related reports for RMC.

19. RMD IBSD RMC Risk Identification Risk Analysis & Assessment Risk Monitoring Understanding Risk & Risk Management 20.

Does Islamic banking risk differ fromConventionalbanking risk?

Not different - just a very special case

• Trade credit ?

• Asset backed Secured or unsecured ?

• Debt or equity ?

• Leasing / Ijara

• Repos / Murabaha ?

• Fund management ?

Islamic Banking is about who bears risk!

21.

• Islamic Banking is safer as it is not based on Interest!

• Depositors are liable to share losses, therefore solvency risk is mitigated!

22. Askari Bank (Islamic) Sharia non Compliance Risk Displaced Commercial Risk Equity Investment Risk Rate of Return Risk Credit Risk Market Risk Liquidity Risk Operational Risk Legal Fiduciary Reputation Strategic Transparency Regulatory compliance Generic Unique 23.

• Credit Risk

• Market Risk

• Liquidity Risk

• Operational Risk

24.

Even generic risks are not straight forward.

For financing that involves financing assets e.g.

• • Murabaha, Salam, Istisna and Ijarah.

• • The risks of financing may transform from credit to market and vice versa at different stages of the contract.

Hence capital requirement needs to take into account both the credit and market risk.

25.

Murabaha:

• Bank sells assets it already owned to customer at cost plus something.

Murabaha Purchase Ordered (MPO)

• Bank sells assets it acquires to customer at cost + based on promise to purchase (PP) by customer.

26.

Market Risk

• Asset available for sale (asset on balance sheet).

Credit Risk

• Assets is sold to and payment is due from customer.

27.

Credit Risk

• Asset available for sale (asset on balance sheet).

• Asset is sold to and payment is due from customer.

28.

Operating Ijarah

• Bank owns the assets whilst transferring the right to use the asset to lessee. Liabilities & risk pertaining to the asset is born by bank.

Ijarah Muntahaia Bittamleek

• Bank promise to transfer the asset by sale or hibah & must be separately expressed and independent of underlying Ijarah.

29.

Market Risk

• Asset available for lease (prior to signing of a lease contract).

• Upon signing a leasing contract and the asset is available for lease.

• Maturity of contract term and the leased asset is returned to the bank.

Credit Risk

• Upon signing a leasing contract and the asset is available for lease.

30.

Market Risk

• Asset available for lease (prior to signing of a lease contract).

Credit Risk

• Upon signing a leasing contract and the asset is available for lease.

31.

Shariah Non-Compliance Risk

• Risk arises from the failure to comply with the Shariah rules and principles.

Displaced Commercial Risk

• The risk that the bank may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by investment account holders.

• The bank foregoes part or its entire share of profit in order to retain its fund providers and dissuade them from withdrawing their funds.

Equity Investment Risk

• 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.

• The risk is relevant under Mudarabaha and Musharakah contracts.

32.

Rate of Return Risk

• The potential impact on the returns caused by unexpected change in the rate of returns.

• • Associated with the management of assets & liabilities.

• • Fixed rate long term assets funded by variable rate short term liabilities.

• • Movement in benchmark rates may result infund providers having expectations of a higher rate of return.

• • If Islamic bank does not yield to market pressure, they may lose their fund providers which could consequently lead to liquidity risk.

33. Gross Income Net Distributable Income Income from Investment Income from Financing Income from IMM Investing Less: Net trading Income and other income. Financing and investment loss provision. Profit Equalization Reserve Direct Expenses Depositor Islamic Bank Profit Sharing Ratio 34. Customer Askari Bank (Islamic) Depositors Revenue Financing Dividend/ Hibah Deposit 35.

ASSETS

Asset-backed transactions

• Murabaha,

• Ijarah,

• Istisna

• Salam.

Profit Sharing Transactions

• Mudarabaha/ Musharakah

Fee Based Services

LIABILITIES

Demand Deposit.

Investment Accounts.

• Mudarabaha

Special Investment Accounts

• Mudarabaha

Equity

Restricted Investments Direct Investors Balance Sheet Off Balance Sheet 36.

Six, full fledge Islamic banks.

Twelve, conventional banks having Islamic banking windows/ branches.

• Askari Bank.

37. 38. Is Askari Banks Portfolio similar to the Islamic Banking Industry outlook! Banking Industry Islamic Banks Share of Islamic Banks # Rs (Million) # Rs (Million) # Rs (Million) Corporate 26,061 1,520,130 1,959 62,784 7.5% 4.1% SME 185,039 437,351 2,685 12,535 1.5% 2.9% Agriculture 1,415,353 150,777 159 13 0.0% 0.0% Consumer Finance 3,025,463 371,421 36,533 28,843 1.2% 7.8% Commodity Finance 2,616 148,447 31 1,118 1.2% 0.8% Others126,021 72,758 1,148 2,459 0.9% 3.4% Total 4,780,553 2,700,883 42,515 107,752 0.9% 4.0% 39.

The previous table shows that consumer finance, with a share of more than 25% in the total credit base of Islamic Banks, is almost totally concentrated in

• Auto Financing.

• Housing Financing.

This is because Islamic banking is based on asset-backed transactions.

40.

Lack of exposure to Unsecured products has actually insulated Islamic Banks from the adverse impact of the weakening Macroeconomic environment, in which the borrowers ability to service their loans can be potentially impaired.

41.

Non Performing Financing (NPF) to Financing.

Net NPFs to Net Financing.

Net NPFs to Total Assets

Provisions to NPFs

Net NPFs to Total Capital

• Mar-08 Jun-08

• 1.5% 2.1%

• 0.2% 0.8%

0.1% 0.4%

84.2%2.2%

0.92% 3.3%

42.

Murabaha 44.5%

Ijarah 24.0%

Musharaka 4.6%

Mudaraba 0.3%

Diminishing Musharaka 25.6%

Salam 1.4%

Istisna 1.0%

Qarz-e-Hasna 0.0%

Others 1.6%

Source: SBP Strategy Paper 43. Providing an architecture that governs theoverall risk management philosophy and strategy Acting as a foundation to allow management of risksto be conducted most effectively in line withthe industrys best practices Setting a tone for the philosophical & practicalapproaches in managing risk 44.

• Management Awareness and Self Assessment.

• Risk Profiling.

• Customer Rating.

• Key Risk Indicators (KRI).

• Portfolio/ Exposure Tracking.

• Value at Risk (VAR).

• Profile of borrowers.

• Maturity of loans.

• Loan products.

• Sector Analysis of loans.

• Large Exposure to individuals and connected parties.

• Loan and other asset classification and provisioning.

• Analysis of loans in arrears.

• Connected lending.

45.

Shariah Non Compliance should be one of our Key Risk Indicator (KRI) parameter.

46.

Appropriate Credit Strategy, including:

• • Pricing.

• • Tolerance for undertaking various credit risks.

A credit risk management structure with effective oversight of credit risk management.

An appropriate measurement and careful analysis of exposures, including market & liquidity sensitive exposures.

47.

High level documents which cut across various silos of risk to establish the Enterprise wide Risk Management Framework in the bank.

48.

• Risk Appetite of the Bank.

• The banks plan to grant credit based on the following:

• • Various Client Segments & Products,

• • Economic Sectors,

• • Geographical Location,

• • Currency,

• • Maturity.

• The Target Market within each lending segment, preferred level of diversification/ concentration.

• Pricing Strategy.

49.

Detailed & formalized credit evaluation/ appraisal process.

Credit Approval Authority at various levels of hierarchy, including Exceptions. E.g.

• • HOCC.

• • Branch Manager.

Risk identification, measurement, monitoring & control.

Risk acceptance criteria.

Credit origination & credit administration and loan documentation procedures.

Roles & responsibilities of staff involved in origination & management of credit.

Guidelines on management of problem loans. (off-loading etc).

50.

Risk appetite determines risk exposure.

Risk diversification & asset allocation strategies applicable to each

• • Islamic financing instrument.

• • Economic activity.

• • Geographical spread.

• • Season.

• • Currency.

• • Tenor.

51.

Bank should ensure:

• The expected rate of return on a transaction is commensurate with the risks incurred.

• Following are managed effectively:

• • • Excessive Credit Risk

• • • • (individual & portfolio levels)

• • • Excessive Risk Concentration

• • • • E.g. financing instruments, economic activity, geographical spread.

52.

• To monitor the condition of ongoing individual credits to ensure the financings are made in accordance with the policies & procedures.

• To manage problem credit situations according to an established remedial process.

• To ensure adequate provisions are allocated.

53.

Take into account seasonal aspects resulting from a shifting or termination of use of certain financing instruments, thus affecting the overall concentration exposures of the financing portfolio.

• E.g.

• • Bank may offer Salam contracts during a certain season where a product can most likely be delivered & sold at maturity .

54.

The due diligence process may include:

• Value at Risk,

• Stress Testing,

• Sensitivity Analysis.

Business Purpose.

Operational Capability.

Enforcement & economic substance of the proposed project, including:

• Future Cash Flows.

55.

• Bank should engage appropriate technical experts:

• • to evaluate the feasibility of a proposed new project.

• • To assess and approve progress billings to be made under the contract.

56.

Appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic instrument.

57.

• Pledge of assets as collateral.

• • Inventories, Shares, Sukuk, Unis, etc.

• Third party Guarantee.

• Personal Guarantee.

• Promise.

• Takaful.

• Urbun.

• Khiyar / Option.

• Parallel contract, if permissible.

58.

Methodology for setting markup rates according to risk rating of the counterparties.

• Pricing as per expected risks.

• Permissible & enforceable collateral & guarantees.

• Clear documentation as to whether or not purchase orders are cancelable.

• Clear procedures for taking account of governing laws for contracts relating to financing transactions.

Limits on the degree of reliance.

Enforceability of collateral & guarantees.

• Usage, redemption & utilization of collateral if the counterparty defaults in payment.

Necessary action incase a customer cancels a non-binding purchase order.

59.

• Administrative:

• • Debt rescheduling.

• • Restructuring.

• Financial:

• • Imposing penalties.

• • Enforceability of collateral.

Inability to use penalty rates as a deterrent against late payments could create both higher risk of default and longer delays in repayments.

60.

If leased assets are impaired through no default of Lessee, then bank would:

• Provide Lessee with a replacement asset with similar specifications.

• • E.g.Ijarah

• Proper risk management policy to mitigate losses arising from such damage, during the term of the lease.

61.

Ensure Shariah compliant insurance coverage of the value of the assets.

62.

Bank bears the risks associated with the leased assets and cannot use lessees guarantees to recover the amount of the losses on the leased assets, unless these are due to:

• • Misconduct,

• • Negligence,

• • Breach of Contract.

• On part of the Lessees.

63.

A policy for determining and allocating provisions:

• Doubtful debts including counterparty exposures.

• Estimated impairment in value of leased assets.

64.

E.g.

• Bank enters Istisna contract as sellers to provide manufactured goods or a building to a customer.

• Then bank enters into another parallel Istisna contract as buyers with a supplier (manufacturer or builder), using specifications drawn up for the original contract.

• If the supplier fails to deliver the manufactured goods or the building according to the agreed specifications, Bank would be in default of their obligation.

65. Thanks A lot! Fahad Zafar Mayfair Business Consultants Lahore, Pakistan.