Islamic Finance & Risk Mitigation IIFM Industry Seminar on Islamic Capital and Money Market Jakarta, May 5, 2014 Assalamu alaikum warahmatullahi wabarakatuh الس ال م ع ل ي ك م و ر ح م ة اهلل و ب ر ك ات ه May the peace, mercy, and blessings of Allah be with you 2 1
Today s Agenda A Point of View Islamic Finance Risk Risk Mitigation & Management Moving Forward Final Remarks 3 A Point of View 4 2
Risk Management & Bank Failures Risk Management in conventional banking is compromised Excessive Leverage & Systemic Risk Excessive Leverage Greed Stupidity Leeds to increased size beyond manageability Debts are socialized if things go wrong & we Start Again with point 1 We will not abolish greed or stupidity but we must address excessive bank leverage. If not, another storm will wreak havoc Robert Jenkins, Former Member of the Financial Policy Committee of the Bank of England in the Financial Times, April 17, 2014 Conventional Risk Financial risk Business risk Operational risk Event risk Can Islamic Finance do better or will we fall in the same trap? 5 Islamic Finance As Game Changer Islamic Finance is well positioned to become the new face of Banking Islamic Finance Is A Game Changer The Basic Equation No Conflict With Religious Principles Ethical Value & Social Justice (Maqasid Al- Shariah) Risk & Profit Sharing Real Economic Transactions & Asset Backed Prohibited Activities & Elements Islamic Finance What is needed? Operational Infrastructure Build From Ground Up on These Principles State-of-the-Art Risk Management & Governance following the same Principles 6 and We NEED Globally accepted Baseline Standards To succeed 3
Increasing Risk Islamic Banking & Investment Products Need Standards for global relevance & risk mitigation Low General products of an Islamic Capital market Products Government Sukūk (lowest risk) Main contracts Ijārah, Istisna, Salam, Corporate Sukūk (medium risk) Public equity (medium risk) Islamic REITS (medium risk) Islamic venture capital/private equity (high risk) Ijārah, Istisnā, Murābahah Mushārakah, Mudhārabah Ijārah, Ijārah Thumma Bay, Wakālah Mushārakah, Mudhārabah Need of Globally Accepted BASELINE Standards Islamic derivatives/ structured products (highest risk) Murābahah, Wa ad (promise), Urboun, Salam 7 High What are standards & why are they important? Banking & Finance General Standards Standards not only mitigate risk, but also dramatically reduce cost of operations 4
Islamic Finance Risk & How to Mitigate It 9 Case Study: Why We Need Standards & Sound Risk Mitigation Procedures Background An Islamic Bank has successfully sued two British men for $432m in a long-running fraud case. A and B, who have been in jail since 2008 were found guilty in a Dubai court of fraud and bribing banks employees. The accused borrowed $501m from the bank over several years, using fake trade contracts to provide short-term funding via Islamic products based on murabaha, whereby the bank would buy goods and, through xxx as its agent, sell the goods to the purchaser, keeping the profit. The fraud occurred when fake supply contracts were drawn up by XXX and submitted to the bank for financing. In some cases, the prices charged on the fake invoices were vastly different from market prices The fraud was uncovered by a bank employee who took over responsibility of the relevant account in the second half of 2007. Name Disguised Year of occurrence KRI Data Base Risk Profile Year 2001 to 2007 Reported Lost $501m 10 Source from Arabian Business.com Line of Business Involved Parties Risk Category How Corporate Lending on products based on Murabahah principle Bank employee Corporate Fraud and Bribing; Governance; Operations; Documentation; Business Control Fake trade contracts Fake invoice with maniplulated pricing 5
Islamic Finance Points of Reference Underlying Philosophy Which Need To Be Embedded In The Risk Management Culture High ethical values Justice Fairness Trust Honesty Integrity Benefits to society, e.g. more equitable distribution of wealth Prevention of harm & avoidance of vices Protection of religion, life, lineage, intellect and wealth the five necessities. Maqasid al- Shari ah (Objectives of Islamic law) Help to process valid examination of text and intact interpretation to produce Islamic rulings 11 Risk In The Financial Services Industry Conventional and Islamic institutions share comparable challenges in risk management Islamic Sharia-compliance Islamic Finance Principles & Philosophy Real transaction (asset based) Ethical behavior Conventional Financial risk Business risk Operational risk Event risk Conventional Financial risk Business risk Operational risk Event risk but the compliance requirements for Islamic Finance are stricter 12 6
Common Banking Specific Risk Categories Islamic Finance Specific Risk Categories Unique Risk Profile of Islamic Finance The underlying principles of Islamic Finance require alignment of the risk management processes Rate of Return Risk Shariah Non- Compliant Risk Equity Investment Risk Commodities & Inventory Risk Displaced Commercial Risk Islamic Finance Risk Categories Credit Risk Operational Risk Market Risk Liquidity Risk Strategy Risk Legal Risk Fiduciary Risk Reputation Transparency Regulatory Compliance Fraud Detection, Early Warning Systems, Capital Adequacy Transactional & Operational Risks Different Sharia'a interpretation can exacerbate risk View 2 View 1 Reject interest-based instruments Accepts interestbased instruments Most derivatives are deems to be haram as they consist of the element of gambling View 3 Different views in handling liquidity problems due to different Sharia'a interpretation 14 Standardisation is needed 7
Liquidity Risk More prevalent in Islamic financial institutions Common sources of liquidity for Islamic Banks Equity financing Bank credit lines Debt based arrangement (Murabahah, MPO and BBA) 15 With equity markets depressed and bank credit constrained, debt securities offer a potential alternative The deposit liabilities for Islamic banks are mostly very short term in nature, but the assets are long term Islamic financial institutions are restricted to borrow interest-based funds with ample supply in the financial market Hence it is difficult to run mismatched asset and liability portfolios Hence, we Need of Globally Accepted BASELINE Standards for risk management & customer education Risk Mitigation & Management A Revolving Cycle 16 8
Communication & Governance Effective risk mitigation requires clear communication of the risk management strategy & the nurturing of a risk culture Governance Stakeholders Risk is a top management concern How seriously risk is taken at the top, determines how seriously it is taken throughout the organization We need to weave risk into the DNA of our organizations 17 Forces Of Change In Risk Management Strengthening capabilities in Governance - Structure of risk function - Define roles responsibilities - RM policies & reporting Process - Process in place to execute RM - Core business processes & procedures People - Have the right skilled people - Right training & risk awareness culture Technology -IT systems used to analyze RM - Enable risk-intelligent decisionmaking decision 18 9
The Risk Mitigation Process Risk Management is a revolving cycle Lessons learned from past project Identify risks Intensive understanding of Customer Know Your Customer and proposed projects will lead to financing of worthy causes with reliable & trustworthy management Continuously Enhance The Risk Management Framework Risk Management Framework Place Risk And Return In Harmony Banks have Baseline Risk Management Frameworks already in place. These Framework need to be enhanced under consideration of Islamic Finance Principles & consideration of the unique Risk Profiles of Islamic Finance Monitor & Fine- Tune Risk Mitigation Strategy Identify Early Warning Signs Develop Risk Mitigation Strategy 19 The Aspirational Target or Gold Standard A new approach to risk assessment & risk mitigation is essential Early Warning, Business Control and Crisis Management Command & Control Center operating 24/7 in a highly secure facilities are now deployed by leading financial institutions 10
Key challenges facing International Islamic Financial Services (IIFS) Key challenges identified are... 1. Governance: Strong commitment from Boards, SSBs and Executives 2. Risk Mitigation: Development of effective Enterprise Risk Management (ERM) program 3. Standards: Implementation of Islamic finance industry s standards 4. Capabilities: Creation of a riskawareness culture and training of staff 5. Process & IT: Enhancing technology and risk information management 6. Global Regulatory Acceptance: Alignment to international regulatory & governance changes Source: Deloitte Islamic Finance Center Research 21 Moving Forward Islamic Finance The New Face of Banking 22 11
Getting momentum We need to Accelerate Our Efforts to standardise operations & risk mgmt to make Global Islamic Finance a viable option Continue innovating structures such as convertible feature Capacity building and talent development Development of a liquidity management infrastructure Strengthening rating processes Strengthening financial safety nets Development of infrastructure required for secondary market Effective crisis management and resolution framework Accounting, regulatory and disclosure standards 23 Final Remarks... 24 1. Reset: Build a truly Islamic Finance Operating & Risk Management Infrastructure not just a derivative of conventional banking 2. Build The Infrastructure: Incubate a Global Platform for Islamic Finance Technology (IT), Operations & Research 3. Global Standards: Develop & adopt standardization on a global basis 4. Islamic Accounting Principal: Harmonize Islamic Finance Accounting Standards & Obtain Global Acceptance 5. Prudential: Work with Regulators on Regulatory Harmonization for Islamic Finance 6. Train Our Future: Provide massive training & awareness building for Islamic Finance on a global scale and enhance transparency and accountability 7. Spread the word: Embrace & Actively sell Islamic Finance Products & Services to Islamic & non-islamic communities alike 8. Talk To Peers: Give first choice to vendors & consulting firms which have institutionalized the philosophy and spirit of Islamic Finance and its Foundations 12
Credits Co-authors & Contributors Dr Hatim El-Tahir Deloitte Islamic Finance Knowledge Centre Daud Vicary Abdullah, Former Deloitte Global Islamic Finance Leader Gary Chin Deloitte Islamic Banking Technology & Business Architect 25 and finally There is much to do & not a moment to lose 26 13
oh, and one more thing new and unexpected competitors are emerging Social Media & Crowd Financing Sharia Compliant Crowd Financing Thank You For Your Attention 28 14
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