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IIFM Industry Seminar on
Islamic Capital and Money Market
Jakarta, May 5, 2014
Islamic Finance & Risk Mitigation
© 2014 Deloitte 2
Assalamu’alaikum
warahmatullahi wabarakatuh
وبركاتهالسالم عليكم ورحمة اهلل
May the peace, mercy, and
blessings of Allah be with you
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© 2014 Deloitte
Today’s Agenda
A Point of View
Islamic Finance Risk
Risk Mitigation & Management
Moving Forward
Final Remarks
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© 2014 Deloitte 4
A Point of View
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© 2014 Deloitte
Risk Management & Bank Failures Risk Management in conventional banking is compromised …
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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
Conventional Risk • Financial risk
• Business risk
• Operational risk
• Event risk
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
Can Islamic Finance do better or will we fall in the same trap ?
© 2014 Deloitte
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
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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
… and We NEED Globally accepted Baseline Standards
To succeed
State-of-the-Art Risk Management & Governance following the same Principles
Operational Infrastructure Build From Ground Up on These Principles
What is needed ?
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Government Sukūk
(lowest risk)
Public equity
(medium risk)
Islamic venture
capital/private equity
(high risk)
Islamic derivatives/
structured products
(highest risk)
Islamic Banking & Investment Products Need Standards for global relevance & risk mitigation
Corporate Sukūk
(medium risk)
Islamic REITS
(medium risk) Ijārah, Ijārah Thumma
Bay, Wakālah
Ijārah, Istisnā’,
Murābahah
Mushārakah,
Mudhārabah
Mushārakah,
Mudhārabah
Murābahah, Wa’ad
(promise), Urboun, Salam
Ijārah, Istisna’, Salam,
Products
Incre
asin
g R
isk
Main contracts
Need of
Globally
Accepted
BASELINE
Standards
Low
High
General products of an Islamic Capital market
What are standards & why are they important ?
Standards not only mitigate risk, but also dramatically reduce cost of operations
Banking & Finance General Standards
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Islamic Finance Risk & How to Mitigate It
Case Study: Why We Need Standards & Sound Risk Mitigation Procedures
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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.
Source from Arabian Business.com
KRI Data Base Risk Profile
Year of
occurrence Year 2001 to 2007
Reported Lost $501m
Line of
Business
Corporate Lending on products based on
Murabahah principle
Involved Parties • Bank employee
• Corporate
Risk Category Fraud and Bribing; Governance; Operations;
Documentation; Business Control
How • Fake trade contracts
• Fake invoice with maniplulated pricing
Name Disguised
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© 2014 Deloitte
Maqasid al-Shari’ah
(Objectives of Islamic law)
Protection of religion, life, lineage, intellect and wealth – the five necessities.
High ethical values
• Justice
• Fairness
• Trust
• Honesty
• Integrity
Benefits to society, e.g. more equitable distribution of wealth
Prevention of harm & avoidance of vices
Help to process valid examination of text and intact interpretation to produce Islamic rulings
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Islamic Finance Points of Reference Underlying Philosophy Which Need To Be Embedded In The Risk Management Culture
© 2014 Deloitte
Risk In The Financial Services Industry Conventional and Islamic institutions share comparable challenges in risk management
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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
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Unique Risk Profile of Islamic Finance The underlying principles of Islamic Finance require alignment of the risk management processes
Islamic Finance
Risk Categories
Commodities & Inventory Risk
Shariah Non-Compliant Risk Equity Investment
Risk
Displaced Commercial Risk
Credit Risk
Market Risk Liquidity Risk
Operational Risk
Strategy Risk Legal Risk Fiduciary Risk Reputation Transparency Regulatory Compliance
Isla
mic
Fin
an
ce
Sp
ecif
ic R
isk C
ate
go
ries
C
om
mo
n B
an
kin
g
Sp
ecif
ic R
isk C
ate
go
ries
Rate of Return Risk
Fraud Detection, Early Warning Systems, Capital Adequacy
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Different views in handling liquidity problems due to different Sharia'a
interpretation
Reject interest-based instruments
Accepts interest-based instruments
Most derivatives are deems to be haram
as they consist of the element of gambling
View 1
View 2
View 3
Transactional & Operational Risks Different Sharia'a interpretation can exacerbate risk
Standardisation is needed
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Liquidity Risk More prevalent in Islamic financial institutions
• 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
Common sources of liquidity for Islamic Banks
Equity financing
Bank credit lines
Debt based arrangement (Murabahah, MPO and BBA)
Hence, we Need
of Globally
Accepted
BASELINE
Standards …for risk management &
customer education
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Risk Mitigation & Management A Revolving Cycle
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Communication & Governance Effective risk mitigation requires clear communication of the risk management strategy & the nurturing of a risk culture
• 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
Governance Stakeholders
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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 decision-
making decision
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Identify risks
Place Risk And Return In Harmony
Develop Risk Mitigation Strategy
Identify Early Warning Signs
Monitor & Fine-Tune Risk
Mitigation Strategy
Continuously Enhance The Risk
Management Framework
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Lessons learned from past project
Intensive understanding of Customer “Know Your
Customer” and proposed projects will lead to financing of worthy causes with reliable
& trustworthy management
The Risk Mitigation Process Risk Management is a revolving cycle
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
Risk Management Framework
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
The Aspirational Target or “Gold Standard” A new approach to risk assessment & risk mitigation is essential
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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 risk-
awareness 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
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Moving Forward Islamic Finance The New Face of Banking
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Getting momentum We need to Accelerate Our Efforts to standardise operations & risk mgmt … to make Global Islamic Finance a viable option
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Continue innovating structures such as
convertible feature
Development of a liquidity management
infrastructure
Strengthening financial safety nets
Effective crisis management and
resolution framework
Accounting, regulatory and disclosure
standards
Development of infrastructure required for secondary market
Strengthening rating processes
Capacity building and talent development
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Final Remarks . . .
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
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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
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There is much to do & not a moment to lose
… and finally
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… oh, and one more thing … new and unexpected
competitors are emerging
Social Media & Crowd Financing
Sharia Compliant Crowd Financing
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Thank You For Your Attention
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© 2014 Deloitte
