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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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© 2014 Deloitte 9

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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© 2014 Deloitte 17

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

18 © 2014 Deloitte

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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© 2014 Deloitte

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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© 2014 Deloitte

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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© 2014 Deloitte

… oh, and one more thing … new and unexpected

competitors are emerging

Social Media & Crowd Financing

Sharia Compliant Crowd Financing

© 2014 Deloitte 28

Thank You For Your Attention

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© 2014 Deloitte