LECTURE 13 �Risk Management for Islamic Bank: Introduction

Islamic Banking Management

FEB UI

Wahyu JATMIKO, PhD

wahyujatmiko@ui.ac.id | w.jatmiko09@gmail.com

May 2022

Objectives

• Basic concept of risk
• Risks in the conventional banks
• Risks in the Islamic banks
• Risk management and its implementation

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Reading Materials

HAL Ch. 10, 15

VAN Ch. 5, 8, 9, 10, 13

WAH Ch. 1, 2, 3

Basic concept of risk

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Introduction to Risks

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Risk Society—natural risks vs. manufactured risks
• Safety and Security—overall goals of society
• Risk and uncertainty are central in economic activities
• Any activity whose performance extends to the future entails uncertainty
• Risks involve both opportunities and threat
• Can be either positive or negative
• Extreme risk aversion and avoidance result in forgoing gainful opportunities and reduce innovation and growth
• Key to any economic activity is to undertake the risks that are gainful and mitigate the ones that are harmful

Concepts of Risks

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Some definitions:
• “a possibility of more than one outcome”
• “existence of uncertainty about future outcomes”
• “difference between expected and actual result”
• Uncertainty classified as general and specific
• General: ignorance of any potential outcome (unknown unknowns)—termed as ‘uncertainty’
• Specific: when objective/subjective probabilities can be assigned to potential outcomes—this is usually referred to as risk (known unknowns)—termed as ‘risk’
• Note: Risk perceptions and its management are shaped by cultural values and legal norms/principles

Class Activity

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

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Between uncertainty and risk: How should we define gharar?

Risks and Implications

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Risk management in a broader sense
• Economy: Promote innovation and growth
• Households: Provide security (particularly to the poor)
• Firms: Reduce losses and maximize value
• For firms risks are costs resulting from higher risks/volatility
• Losses
• Bankruptcies
• Objectives of risk management include:
• Reduce risks/volatility
• Maintain a certain risk profile
• Value maximization
• Risk—usually measured by the variability or volatility of outcomes—variance or standard deviation

Risk Exposure Classifications

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Risk exposures can be examined under following headings
• Risk types—origins/causes
• Degree of expectancy of an event
• Impact magnitude/severity

Risk Types—Origins/Causes

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Exogenous/External
• Natural: disasters such as floods, earthquakes, etc.
• Human: external fraud, computer hacking, regulatory/legal uncertainty, etc.
• Endogenous/Internal
• Normal business risks: market, credit, operational, etc. arising in normal business transactions
• Manufactured risks: Creation of news risks

Expectancy of Event & Impact

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Expectancy—likelihood or probability
• Probability or likelihood can be low, medium and high
• Implies knowledge of risk event and its expectancy
• Impact translates to losses
• Losses—ex-ante vs. ex-post concepts
• Expected losses—ex-ante
• Expected losses that occur regularly (e.g., a certain percentage of clients defaulting)
• Has a known probability
• Unexpected losses
• Losses cannot be foreseen (e.g., natural disasters)
• Actual losses (ex-post)= Expected losses ± unexpected losses/gains

Impact-Likelihood of Events and Risk Tolerability Matrix

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Sources/Impact/Likelihood and Risk Management

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Probability/impact can arise from various sources
• Credit
• Market
• Operational
• etc.
• Losses can be classified into the following:
1. Low likelihood/low impact (acceptable)
2. High likelihood/low impact (needs focus)
3. Low likelihood/high impact (can be disastrous)
4. High likelihood/high impact (implausible)
• Risk Management means reducing
• Likelihood/probability of occurrence
• Impact

Islamic Perspectives on Risks (1 of 2)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Three types of risks

• Essential risk: inherent in all business transactions (entitlement to profit linked to risk bearing)
• Maxims: al ghurm bi al ghunm and al kharaj bil daman
• Prohibited risk: excessive uncertainty or gharar resulting in oppression or injustice (zulm)—can take different forms
• Uncertainty is dominant
• Derivatives instruments are prohibited due to gharar
• Deceit and fraud
• Permissible risk: does not fall in above two categories (operational, liquidity, etc.)

Islamic Perspectives on Risks (2 of 2)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Allocation of risks between parties to a contract determined by Shari’ah principles
• In some cases risks cannot be reallocated by parties
• Endogenous risks can be divided into two
• Entrepreneurial risks: risks arising in real economic activities—profit must be associated with risk taking
• Incorporeal risks: risks arising in transactions that are not linked to real economic activities economy—not permissible
• Level of uncertainty and gharar
• Probability of gain is less than the probability of loss—excessive gharar
• Probability of gain is greater than the probability of loss— acceptable gharar

Risks in the conventional banks

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Finance and Risks

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• While risks are inherent in all economic activities, they are particularly important in financing & investment as these involve transactions in the future
• Business risks and financial risks
• Business risk relates to uncertainty arising from the nature of firm’s business
• Financial risks relates to movements in the financial variables and market

Risks and Financial Sector

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Functions of the financial sector and growth
• Mobilizing savings, allocating resources, monitoring managers, easing trading of good and services
• Facilitates ‘trading, hedging diversification and pooling of risks’
• Financial sector allocates resources and returns/risks
• Institutions
• Banks—risk management, diversification of risks
• Insurance—diversification and pooling of risks
• Markets and Instruments
• Securities markets
• Equity vs. debt
• Derivatives—transfer risks

GFC and Risks

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risks and Financial Sector

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Functions of the financial sector and growth
• Mobilizing savings, allocating resources, monitoring managers, easing trading of good and services
• Facilitates ‘trading, hedging diversification and pooling of risks’
• Financial sector allocates resources and returns/risks
• Institutions
• Banks—risk management, diversification of risks
• Insurance—diversification and pooling of risks
• Markets and Instruments
• Securities markets
• Equity vs. debt
• Derivatives—transfer risks

Risks in Financial Institutions

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

• Risks related to liabilities (deposits)
• Risks on the assets side
• Banking portfolio
• Trading portfolio
• Risks related to both assets and liability side
• Asset-liability Management (ALM)
• Use of capital/equity for risk management

Assets

Liability & Equity

Banking�Portfolio

Deposits & �Debt

Equity

Trading Portfolio

Risks faced by Financial Institutions (1 of 4)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Credit Risks

Risk that counterparty will fail to meet obligations timely and fully in accordance with the agreed terms

• Loan credit risk:
• counterparty fails to meet its loan obligations timely and fully
• associated with the quality of assets and the probability of default
• Trading credit/settlement risk
• borrower’s inability or unwillingness to discharge contractual obligations in trading contracts

Risks faced by Financial Institutions (2 of 4)

Market Risks

Risk originating in instruments and assets traded in well-defined markets

• Systematic market risk result from overall movement of prices and policies in the economy
• Unsystematic market risk arises when the price of the specific asset or instrument changes

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Types of market risks

• Equity price risk
• Interest rate risk
• Currency risk
• Commodity price risk

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risks faced by Financial Institutions (3 of 4)

Operational risk

Risks arising from ‘failed internal processes, people, and systems and from external events’

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Risk of loss resulting from

• People: risk arising due to incompetence and fraud
• Technology: risk from telecommunications system and program failure
• Process: risk due to errors in model specifications, inaccurate transaction execution, and violating operational control limits.
• Legal & Regulatory : unenforceability of financial contracts (due to statutes, legislation, and regulations that affect the fulfillment of contracts and transactions.

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risks faced by Financial Institutions (4 of 4)

Liquidity risk

Risk arising from insufficient liquidity for normal operating requirements

Reduces the ability of banks to meet its liabilities when it falls due

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Liquidity risk may result from

Funding or financing liquidity risk: difficulties in obtaining cash at reasonable cost from borrowings (liability side)

Trading or asset liquidity risk: difficulty in sale of assets (assets side)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risks in the Islamic banks

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Islamic Banking Practice: 2^nd Best Model

One-tier Mudarabah with Multiple Investment Tools

• Liability Side—PSIA (Mudarabah based)
• Asset Side—multiple investment tools, dominated by fixed-income contracts (murabahah, ijarah, istisna, etc.)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risks faced by IBs (1 of 4)

Risks on the Assets side

• Credit Risk takes the form of:
• Settlement/payment risk
• Counterparty risk (equity investment risk)
• Market Risk is important in Islamic banking
• Systematic—currency, rate of return, and equity risks
• Unsystematic—commodity or asset risks
• Risks in Islamic financial instruments
• As modes are asset-backed or equity based, market risks are important along with credit risks
• Market and credit risks intermingle and transform from one kind to another at different stages of transaction

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risks faced by IBs (2 of 4)

Risks on the Liability Side

• Contractual Nature of Deposits
• PSIA—mudarabah contracts
• Demand deposits—qard hasan
• Need to keep risks separate
• Fiduciary risk—PSIA are fiduciary contracts
• Lower rate of return or non-compliance with Shari’ah can be interpreted as breach of contract – fiduciary risk
• Withdrawal Risk
• Lower returns may lead to withdrawal of deposits—to avoid this, returns from shareholders transferred to depositors—transfer of risks associated with deposits to equity holders (displaced commercial risk)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risks faced by IBs (3 of 4)

Operational Risks

Risks arising from ‘failed internal processes, people, and systems and from external events’

• Person risk—lack of qualified professionals who understand/manage risks in Islamic banking
• Technology risk—computer software and IT for IFIs Legal risks Standardization of contracts
• Lack of statutes and enforcement institutions Shari’ah compliance risk

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Liquidity risk

• Difficulties in obtaining cash at reasonable cost from borrowings (Funding or financing liquidity risk) or sale of assets (trading or asset liquidity risk)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risks faced by IBs (4 of 4)

Shari’ah Compliance Risk

Risks of non- compliance with Shari’ah

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Reputation Risk

Risks arising from ‘failures of governance, business strategy and process’.

• Reputation of IFI and its profitability and market position can be affected by negative publicity about its business practices
• Particularly relating to Shari’ah non-compliance in their products and services

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Unique Risks of Murabaha Financing - Intro

• Islamic banks cannot charge anything in excess of the agreed upon price.
• Prices are sticky (market risk).
• Late payments are prohibited.
• The condition of its validity is based on the fact that the bank must buy (become owner) and after that transfer the ownership right to the client.
• The order placed by the client is not a sale contract but it is merely a promise to buy.

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Unique Risks of Salam Financing - Intro

• The counterparty risks can range from failure to supply on time or even at all, and failure to supply the same quality of good as contractually agreed.
• All the Salam contracts end up in physical deliveries and ownership of commodities. These commodities require inventories exposing the banks to storage costs and other related price (market) risk.

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Unique Risks of Istisna Financing - Intro

• There could be a contract failure regarding quality and time of delivery.
• The default risk on the buyer’s side is of the general nature, namely, failure in paying fully on time.
• The supplier may maintain the option to rescind from the contract.
• The buyer may maintains the option to rescind from the contract.

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Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Unique Risks of Ijara Financing - Intro

• Ownership risks are borne by lessor
• Damage
• Premium cost
• Basic maintenance

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Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk management and its implementation

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Attitudes Towards Risks

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk management evolutions

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Approaches to managing risks

• Inherent risk—risk exposure with no controls or measures
• Residual risk—risk exposure after control and measures are in place
• Moving from inherent to residual risks
• Risk Avoidance—avoiding and not undertaking certain risks
• Risk Transfer—transferring risks to other parties
• Risk Sharing—sharing risks with others
• Risk retention and reduction—risks central to the business and must be absorbed and mitigated by banks

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

From Inherent Risk to Residual Risk

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk Avoidance

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• Banks may opt not go into certain businesses/risks and avoid some other risks
• Examples
• Do not deal with risky derivative instruments
• Risk of theft of cash—do not deal with cash
• Risk of computer crash—always have backup

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk Transfer

• Some risks can be transferred with insurance
• Derivatives are used for transferring risks
• Risks also transferred by selling/buying of financial claims in form of securities (such as Mortgage Backed Securities MBS)
• Credit Default Swaps (CDS)—if there is default, the issuer swaps a fixed return with the return on defaulting asset
• From Islamic perspective—selling of debt and risks not allowed
• Islamic total return swap?

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk Sharing

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• Part of the risks are shared with other stakeholders
• – PSIA—sharing risks with depositors
• – Pure Insurance—risk pooling (mutual or cooperative insurance)
• – Takaful—risk pooling

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk Retention and Reduction

Three key strategies

• Prevention strategy/plan decreases the probabilities of downside risks before the occurrence of risks
• Mitigation strategy/plan to decrease the potential impact of a future downside risk
• Coping strategy/plan reduces the adverse impact of a negative shock by managing the resulting loss after the occurrence of a risk event

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk Retention and Reduction

Prevention strategy (ex-ante) decreases the probabilities of downside risks before the occurrence of risks

• Standardization of all business-related activities and processes
• Construction of diversified portfolio
• Risks in Murabahah—loss/damage of good before delivery by bank
• Risk avoided by minimizing the period of holding (time between purchase and sale)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk Retention and Reduction

Mitigation strategy (ex-ante) to decrease the potential impact of a future downside risk

• Guarantee in a debt contract
• Security or collateral—can sell the collateral if debtor defaults
• Contingency plans (e.g. for liquidity risks)

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Risk Retention and Reduction

Coping strategy (ex-post) reduces the adverse impact of a negative shock by managing the resulting loss after the occurrence of a risk event

• Contingency plans
• Capital to absorb losses
• Credit risk mitigated by Loan Loss Reserves

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Nature of Risks & RM Approaches

Wahyu Jatmiko | Risk Management for Islamic Bank: Introduction

Thank you

Wahyu JATMIKO, PhD

wahyujatmiko@ui.ac.id

w.jatmiko09@gmail.com