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  • 1

    IIFM Industry Seminar on

    Islamic Capital and Money Market

    Jakarta, May 5, 2014

    Islamic Finance & Risk Mitigation

    2014 Deloitte 2

    Assalamualaikum

    warahmatullahi wabarakatuh

    May the peace, mercy, and

    blessings of Allah be with you

  • 2

    2014 Deloitte

    Todays Agenda

    A Point of View

    Islamic Finance Risk

    Risk Mitigation & Management

    Moving Forward

    Final Remarks

    3

    2014 Deloitte 4

    A Point of View

  • 3

    2014 Deloitte

    Risk Management & Bank Failures Risk Management in conventional banking is compromised

    5

    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

    6

    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 ?

  • 4

    7

    Government Sukk

    (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 Sukk

    (medium risk)

    Islamic REITS

    (medium risk) Ijrah, Ijrah Thumma

    Bay, Waklah

    Ijrah, Istisn,

    Murbahah

    Mushrakah,

    Mudhrabah

    Mushrakah,

    Mudhrabah

    Murbahah, Waad

    (promise), Urboun, Salam

    Ijrah, 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

  • 5

    2014 Deloitte 9

    Islamic Finance Risk & How to Mitigate It

    Case Study: Why We Need Standards & Sound Risk Mitigation Procedures

    10

    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

  • 6

    2014 Deloitte

    Maqasid al-Shariah

    (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

    11

    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

    12

    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

  • 7

    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

    2014 Deloitte 14

    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

  • 8

    2014 Deloitte 15

    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

    2014 Deloitte 16

    Risk Mitigation & Management A Revolving Cycle

  • 9

    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

  • 10

    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

    19

    Lessons learned from past project

    Intensive understanding of Customer Know Your

    Customer and proposed projects will lead t

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