risk management in islamic finance 04 - islamic banking

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  • Risk Management in Islamic Banking

    September, 2012

    Shahin ShayanChairman of the BoardHoda International Financial Engineering Company*

    *

  • Original QuestionDoes Risk Management Exist in Islamic Banking?Not as effectively as it should

    Current approaches use Basel II standards without consideration of the differences between the Islamic and Non-Islamic Banking Risk dynamicsDue to the above error, most Islamic Banks end up having to carry more capital than it is requiredIslamic Financial Supervisory Board IFSB has tried to reconcile this problem by coordinating the necessary issues with the BIS and Basel Committees Shahin A. Shayan*

    *

  • Original Question RevisedShould Risk Management Exist in Islamic Banking?Yes, very much soIslamic Banking is based on Risk sharing and Participation contracts on the Asset and Liability sidesIslamic Banks incorporate important Risks as a part of their operations, therefore Risk Management must be taken seriously in Islamic BanksIslamic Banking Risk has some similarities and differences compared to the Non-Islamic Banking operationsIslamic Banking Risk Management approach must have an EWRM and Holistic view incorporating IFSB proposed standards or specific risks of Islamic Banking, as oppose to the strict Basel II approach

    *Shahin A. Shayan

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  • Islamic Banking Risk TypesIn accordance with Basel II & IFSB StandardsStrategic RiskFinancial RiskCredit Risk (Z, Credit Scoring Systems ) Market Risk (Var Analysis, Duration Matching through Sukuk Issuance)Interest Rate, ROR or Inflation Risk (Duration Matching)Currency Risk (Var Analysis)Price (commodity, equity) Risk (Var Analysis)Liquidity Risk (Var Analysis, LGAP, Sukuk Issuance .)Operational Risk which which Includes Shariah Compliance, Other Regulatory Legal Compliances, Fiduciary () and Reputation Risks*Shahin A. Shayan

    *

  • *Basel IIFramework

    Basel II is the second of the Basel Accords, which are recommendations on banking laws and regulations issued by the Basel Committee on Banking Supervision. The purpose of Basel II, which was initially published in June 2004, is to create an international standard that banking regulators can use when creating regulations about how much capital banks need to put aside to guard against the types of financial and operational risks banks face. Advocates of Basel II believe that such an international standard can help protect the international financial system from the types of problems that might arise should a major bank or a series of banks collapse. In practice, Basel II attempts to accomplish this by setting up rigorous risk and capital management requirements designed to ensure that a bank holds capital reserves appropriate to the risk the bank exposes itself to through its lending and investment practices. Generally speaking, these rules mean that the greater risk to which the bank is exposed, the greater the amount of capital the bank needs to hold to safeguard its solvency and overall economic stability.Source: www.wikipedia.comShahin A. Shayan

  • *Basel II final version aims at:Ensuring that capital allocation is more risk sensitive;Separating operational risk from credit risk, and quantifying both;Attempting to align economic and regulatory capital more closely to reduce the scope for regulatory arbitrage.

    Basel II uses a "three pillars" concept (1) minimum capital requirements (addressing risk), (2) supervisory review and (3) market discipline. The Basel I accord dealt with only parts of each of these pillars. For example: with respect to the first Basel II pillar, only one risk, credit risk, was dealt with in a simple manner while market risk was an afterthought; operational risk was not dealt with at all.Source: www.wikipedia.comBasel IIFramework

    Shahin A. Shayan

  • *Basel II Capital StandardsShahin A. Shayan

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  • *Basel IIDevelopment

    Shahin A. Shayan

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  • *Basel II Regulators in most jurisdictions around the world plan to implement the new Accord, but with widely varying timelinesIn response to a questionnaire released by the Financial Stability Institute (FSI), 95 national regulators indicated they were to implement Basel II, in some form or another, by 2015The European Union has already implemented the Accord via the EU Capital Requirements Directives and many European banks already report their capital adequacy ratios according to the new systemSource: www.wikipedia.comBasel IIImplementation Problems

    Shahin A. Shayan

  • *In response to the recent financial crisis, the Basel Committee on Banking Supervision (BCBS) set forth to update their guidelines for capital and banking regulationsThe Basel Committee gave a proposals to strengthen global capital and liquidity regulations with the goal of promoting a more resilient banking sector. The objective of the Basel Committee's reform package is to improve the banking sector's ability to absorb shocks arising from financial and economic stress, whatever the source, thus reducing the risk of spillover from the financial sector to the real economy Basel IIImplementation Problems

    Shahin A. Shayan

  • *Almost from the start of the financial crisis, there has been broad agreement that national and international banking systems needed reform. The Financial Stability Forum (now the Financial Stability Board, or FSB), a global group of regulators and central banks, started developing recommendations on regulatory reform as early as the fall of 2007. Its first findings were published in April 2008, six months before Lehman Brothers failed. Since then, the FSB has continued to develop its recommendations, which are regularly endorsed by the G20 governmentsThe Basel Committee on Banking Supervision (BCBS) has translated the FSBs recommendations into a new regulatory capital and liquidity regime and summarized its work in two consultative documents published in December 2009. The proposal, which many are calling Basel III , is likely to establish the rules for European banks for the next decade at least and to set the tone for local regulation in other parts of the world. The regulator aims to finalize the new rules by the end of 2010Basel IIIFramework & Proposal

    Shahin A. Shayan

  • *BASEL III refers to a new update to the Basel Accords that is under development. The term appeared in the literature as early as 2005 and is now in common usage anticipating this next revision to the Basel Accords. The Bank for International Settlements (BIS) itself began referring to this new international regulatory framework for banks as "Basel III in September 2010The draft Basel III regulations include: tighter definitions of Common Equity; banks must hold 4.5% by January 2015, then a further 2.5%, totaling 7%.the introduction of a leverage ratio (controlling Bank Leverage Ratio),a framework for counter-cyclical capital buffers,measures to limit counterparty credit risk,and short and medium-term quantitative liquidity ratios

    Basel IIIFramework & Proposal

    Shahin A. Shayan

  • *McKinsey & Company has done a research in on November 2010 and suggests that the task will not be easy. Barring any mitigating actions, we estimate that banks in Europe and the United States will have to raise about 1.65 trillion of new capital, about 1.9 trillion of short-term liquidity, and about 4.5 trillion of long-term funding. The capital shortfall is equivalent to about 60 percent of all outstanding Tier 1 capital, and the short-term liquidity gap is about 50 percent of all the liquidity that banks currently hold. Banks are already mobilizing to reprice assets and cut costs further. Whatever they do, the new rules are sure to dent their profits. Our analysis shows that these rules could reduce return on equity (ROE) for the average European bank by between 3.7 and 4.3 percentage points by 2019, from the pre-crisis ROE average of 15 percent (pre-tax). Some banks might be hit even harder. Basel IIIFramework & Proposal

    Shahin A. Shayan

  • *Basel I, II, III XCrazy?

    Shahin A. Shayan

  • Risk Structure in Non Islamic Financial BS*

    AssetsLiabilities & SETotal AssetsTotal Liab. SETotal LiabilitiesStockholder Eq.Shahin A. Shayan

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  • Risk Structure in Islamic Financial BS*

    AssetsLiabilities & SETotal AssetsTotal Liab. SETotal LiabilitiesStockholder Eq.Shahin A. Shayan

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  • *Size of lossesFrequency of lossesExpected LossesUnexpected losses fromCredit, Market &Operational risks

    Income

    Capital InsuranceRisk Management Non Islamic BankSustaining & Managing losses - Lognormal

    Worst Case or Catastrophic LossResidual Risk to be accepted by the bank ShareholdersBasel II Minimum Capital RequirementsProvisions from IncomeShahin A. Shayan

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  • *Size of lossesFrequency of lossesExpected LossesUnexpected losses from PSIA financed assets

    Provisions from Income

    Capital & Investment Risk Reserves Unexpected losses from current accountand capital financed assets Profit Sharing Investment Account, Capital & Profit Eq. ReservesIslamic InsuranceRisk Management Islamic BankSustaining & Managing losses - LognormalShahin A. Shayan

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  • *Managing Risk Based Capital Requirements According to Basel IIExample of VARShahin A. Shayan

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  • Managing Risk According to IFSBProposed Standards Implementation ChallengesIFSB is not empowered to enforce its proposed standards and guidelines. Therefore, the IFSB relies solely on the voluntary adoption of standards by its members and IIFSThe prerequisites to implement these standards imply sound understanding by supervisors and regulators of the risks involved in Shariah compliant transa

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