risk management practices of conventional and islamic banks in bahrain
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The Journal of Risk FinanceEmerald Article: Risk management practices of conventional and Islamic banks in BahrainHameeda Abu Hussain, Jasim Al-Ajmi
Article information:To cite this document: Hameeda Abu Hussain, Jasim Al-Ajmi, (2012),"Risk management practices of conventional and Islamic banks in Bahrain", The Journal of Risk Finance, Vol. 13 Iss: 3 pp. 215 - 239
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Fauziah Hanim Tafri, Rashidah Abdul Rahman, Normah Omar, (2011),"Empirical evidence on the risk management tools practised in Islamic and conventional banks", Qualitative Research in Financial Markets, Vol. 3 Iss: 2 pp. 86 - 104http://dx.doi.org/10.1108/17554171111155339
Abul Hassan, (2009),"Risk management practices of Islamic banks of Brunei Darussalam", The Journal of Risk Finance, Vol. 10 Iss: 1 pp. 23 - 37http://dx.doi.org/10.1108/15265940910924472
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Risk management practices ofconventional and Islamic banks
in BahrainHameeda Abu Hussain and Jasim Al-Ajmi
Department of Economics and Finance, University of Bahrain,Sekheer, Bahrain
Abstract
Purpose The purpose of this paper is to report empirical evidence regarding the risk managementpractices of banks operating in Bahrain.
Design/methodology/approach A sample of bankers was surveyed through a questionnaire andthe results used to examine if the risk management practices are significantly associated with the typeof bank (conventional or Islamic) and if those practices are positively affected by understanding risk,risk management, risk identification, risk assessment analysis, risk monitoring and credit riskanalysis. Several statistical and econometric methods were used to the test the hypotheses.
Findings Banks in Bahrain are found to have a clear understanding of risk and risk management,and have efficient risk identification, risk assessment analysis, risk monitoring, credit risk analysisand risk management practices. In addition, credit, liquidity and operational risk are found to be themost important risks facing both conventional and Islamic banks. Furthermore, the risk managementpractices are determined by the extent to which managers understand risk and risk management,efficient risk identification, risk assessment analysis, risk monitoring and credit risk analysis. Islamicbanks are found to be significantly different from their conventional counterparts in understandingrisk and risk management. The levels of risks faced by Islamic banks are found to be significantlyhigher than those faced by conventional banks. Similarly, country, liquidity, and operational, residual,and settlement risks are found to be higher in Islamic banks than in conventional banks.
Research limitations/implications The results may have been influenced by the currenteconomic global crisis. Although the response rate is very high, there is no evidence of non-responsebias, and there is high internal consistency within the responses. The reliance on survey methodologyintroduces the possibility that respondents expressed their beliefs and did not necessarily describetheir actions.
Practical implications Bankers, depositors, investors and regulators are likely to benefit from theresults of the study when taking decisions related to the banking industry.
Originality/value This is the first published attempt to investigate empirically the riskmanagement practices of banks operating in Bahrain and to compare the practices of conventional andIslamic banks.
Keywords Bahrain, Banks, Risk management, Conventional banks, Islamic banks, Perceptions,Risk management practices
Paper type Research paper
1. IntroductionEffective risk management is accepted as a major cornerstone of bank management byacademics, practitioners and regulators. Acknowledging this reality and the need for acomprehensive approach to deal with bank risk management, the Basel Committee
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1526-5943.htm
JEL classification G20, G21, G28
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Received September 2011Revised November 2011Accepted February 2012
The Journal of Risk FinanceVol. 13 No. 3, 2012
pp. 215-239q Emerald Group Publishing Limited
1526-5943DOI 10.1108/15265941211229244
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on Banking Supervision adopted the Basel I Accords, followed by the Basel II Accordsand recently by the Basel III, to deal with the matter. Moreover, risk management isfound to be one of the determinants of returns of banks stocks (Sensarma and Jayadev,2009). The recent global economic and financial crisis erupted in the USA whenLehman Brothers Holdings, Inc. filed for Chapter 11 bankruptcy on 15 September 2008.The spread of this crisis worldwide raised questions about the effectiveness of riskmanagement practices (RMPs) applied by banks, including those applied bywell-established banks. Risk management failure is considered one of the main causesof the crisis (Bank for International Settlements, 2009; KPMG International, 2009;Sabato, 2009; Holland, 2010). The US Sarbanes Oxley Act of 2002 was enacted inresponse to the boom and bust of the dot.com market and obliges all companies quotedon the US stock exchanges to spend considerable sums of money in order to maintaintheir control systems (Williams et al., 2006). A global survey of 346 financial serviceexecutives conducted in March 2009 by the Economist Intelligence Unit (2010) onbehalf of SAS Inc., aimed to examine how the financial institutions worldwide arestrengthening their risk management capabilities in response to the global crisis.Approximately half of the survey respondents reported that they had conducted, orplanned to conduct, a thorough overhaul of their risk management, includingimprovements to data quality and availability, strengthening risk governance, movingtowards a firm-wide approach to risk and deeper integration of risk within lines ofbusiness. However, only 40 percent of respondents stated that the importance of riskmanagement is widely understood throughout their company, suggesting that moreneeds to be done to embed a strong culture of risk management in financialinstitutions.
Risk management is a continuous process that depends directly on changes in theinternal and external environment of banks. These changes in the environment requirecontinuous attention for identification of risk and risk control. In response to the call toenhance the effectiveness of risk management, banks in Bahrain, like those in manyother countries, are required to comply with Basel II.
Banks in Bahrain are facing an exceptional challenge in managing their riskexposure which came as a result of the continual social and political unrest whicherupted on 14 February 2011. The governments struggle to deal with the democraticmovement resulted in a decline in non-oil economic activities, deterioration of creditrating and a decline in stability of the banking industry. Among those results are:
. the estimated growth rate of gross domestic products (constant prices) in 2011was 1.5 percent, which is lower than IMF prediction of around 4.5 percent beforethe uprising;
. a credit rating cut of two levels by Standard & Poors to the second-lowestinvestment grade; similar moves were taken by Fitch and Moodys;
. the downgrading credit rating increased the yield paid on the recent seven-yearIjarah sukuk issue to 6.273 percent compared with 5.5 percent yield paid on abond maturing in 2020 issued before the uprising; and
. revision of a Banking Industry Country Risk Assessment by Standard & Poorsfrom groups 5 to 6 (group 1 is the lowest risk while group 10 is the highest risk),and finally, drop in assets value; for example, the market capitalization ofBahrain Bourse decline by 19.34 percent from January 2011 to January 2012.
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These consequences indicate that banks are facing higher credit and market risks nowwhen compared with the situation prior to the uprising.
RMPs have been widely investigated over the years. However, little attention hasbeen paid to banks operating in emerging markets and, in particular, Islamic banks(Al-Tamimi, 2002; Al-Tamimi and Al-Mazrooei, 2007; Hassan, 2009). Since riskmanagement failure has been identified as one of the main causes of the financial crisis,additional study of the subject is warranted. The primary aim of this study is tocontribute to the debate about risk management by investigating the RMPs of banksoperating in Bahrain. Specifically, the studys objectives are threefold:
(1) to investigate empirically the degree to which the conventional and Islamicbanks in Bahrain use effective RMPs and techniques in dealing with differenttypes of risk;
(2) to identify the most important types of risk facing the Islamic banks in Bahrain;and
(3) to compare the RMPs of conventional and Islamic banks.
The study extends the work of Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009)who suggest similar studies in different environments. Although the study is anextension of these studies, in another context it differs in at least two aspects:
(1) the questionnaire used is similar but not identical, having been revised aftertaking into account the environment and the opinions of practitioners whocommented on the earlier version of the questionnaire; and
(2) the present study includes a comparison of the practices of conventional andIslamic banks.
The remainder of the paper is divided into four sections: Section 2 provides a briefreview of the literature, Section 3 describes the conceptual framework and themethodology, Section 4 discusses the results and Section 5 presents the mainconclusions, limitations and suggestions for future research.
2. Brief literature review and hypothesesUnlike studies that deal with risk management in general, published empirical studieson the RMPs of financial institutions are relatively rare (Fatemi and Fooladi, 2006;Al-Tamimi and Al-Mazrooei, 2007). Richard et al. (2008) found that banks credit riskmanagement is affected by the environment in which banks operate. This section offersa brief review of recently published studies that are directly relevant to this endeavor.
In a study of the sensitivity to risk of large domestic banks in the USA, Linbo Fan(2004) found that profit efficiency is sensitive to credit risk but not to insolvency risk orto the mix of loan products. Hahm (2004) argues that it is necessary to improvebanking supervision and banks risk management to ensure successful financialliberalization. This is based on a study of interest rate and exchange rate exposure ofKorean banks before the 1997 Asia Pacific economic crisis, which found that theperformance of commercial banks was significantly associated with their pre-crisisrisk exposure (Table I).
Fatemi and Fooladi (2006), after investigating the current practices of credit riskmanagement in the largest US-based financial institutions, report that identifying
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counterparty default risk is the single most important purpose served by the credit riskmodels utilized. However, it should be noted that these results are based on a very lowresponse rate, i.e. 21 responses to questionnaires sent to 100 banks.
Al-Tamimi and Al-Mazrooei (2007) provide a comparative study of banks riskmanagement in locally incorporated banks and foreign banks in the United Arab ofEmirates (UAE). The results show that the three most important types of risks facingUAE commercial banks are foreign exchange risk, followed by credit risk andoperating risk. However, an earlier study by Al-Tamimi (2002) reports that the mainrisk facing UAE commercial banks is credit risk. For risk identification (RI), he reportsthat inspection by branch managers and financial statement analysis were the mainmethods used; while Al-Tamimi and Al-Mazrooei (2007) report that inspection by thebank risk manager, audits or physical inspections, financial statement analysis andrisk survey are the main methods used. These results indicate that banks are becomingmore sophisticated in managing their risk. The authors also report that the locallyincorporated banks are fairly efficient in managing risk; however, the variables such asRI, assessment and analysis have proved to be more influential in the risk managementprocess. Finally, their results indicate that there was a significant difference betweenthe UAE national and foreign banks in understanding risk and risk management(URRM), practicing risk assessment and analysis (RAA), and in risk monitoring(RMON) and controlling, but not in RI, credit risk analysis (CRA) and RMPs. Onaverage, they report that foreign banks are better than locally incorporated banks indealing with risk exposure. A difference in the quality of the staff is the primary reasonoffered by the authors to account for such significant differences. Additionally, onecould add differences in regulatory requirements that banks are subject to as a possiblereason for such results. Branches of foreign banks, such as Citibank, HSBC andStandard Chartered Bank, are required to comply with the regulatory requirementsthat their parent companies are subject to, which might be more rigorous than thoseapplied by the Central Bank of the UAE.
Al-Tamimi (2008) studied the relationship between the readiness to implement theBasel II Accord and the resources needed to implement it in UAE banks. The resultsrevealed that these banks are aware of the benefits, impact and challenges associatedwith the implementation of the Basel II Accord. However, the research did not find anypositive relationship between the UAE banks readiness to implement Basel II and theimpact of that implementation. Nor was the relationship between readiness andanticipated cost of implementation confirmed. No significant difference was found inthe level of preparation for the Basel II Accord between the UAE national and foreignbanks. It was concluded that there was a significant difference in the level of the UAE
Risk management aspects Cronbachs a
URRM 0.892RI 0.713RAA 0.834RMON 0.850RMPs 0.872CRA 0.729All aspects 0.961
Table I.Internal consistencyof the six riskmanagement aspects
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banks in relation to Basel II, based on employees educational levels. The resultssupported the importance of education for the implementation of the Basel II Accord.
Hassan (2009) reports that, like the conventional banks, Islamic banks are alsosubject to a variety of risks due to the unique range of products offered. He also showsthat there was a remarkable understanding of risk and risk management among thestaff working in the Islamic banks of Brunei Darussalam, which proved their ability tomanage risk successfully. The major risks that were faced by these banks were foreignexchange risk, credit risk and operating risk. A regression model was used to developthe results, which showed that RI, and RAA were the most influential variables, and theIslamic banks in Brunei needed to give more attention to those variables to make theirRMPs more effective. Understanding the true application of the Basel II Accord canimprove the efficiency of Islamic banks risk management systems.
Van Greuning and Iqbal (2008) and Iqbal and Mirakhor (2011) argue that acomprehensive framework of risk management is equally applicable to a conventionalor Islamic bank. The findings of Hassan (2009) lend further support to this argument.Khan and Bhatti (2008) observed that Islamic banks face another crucial challenge toimproving their risk management strategies and corporate governance because of theiradherence to Islamic Shariaa (law). This should have an impact on the risk managementof Islamic banks in terms of certain applications, emphasis and inclusion or exclusion.
Taking into account the above review and the objectives of the study, the researchquestions that this study aims to address are:
RQ1. Do bankers understand risk and risk management?
RQ2. Do banks identify the potential risk to which they are exposed?
RQ3. Do banks have in place a system for assessing and analyzing risk?
RQ4. Do banks monitor and control risks efficiently?
RQ5. Do banks have efficient risk management?
RQ6. Do banks analyze credit risk efficiently?
RQ7. What types of RI methods do banks use?
RQ8. What are the types of risks to which banks are exposed?
Based on the above review and the research questions, the following hypotheses,phrased in a null form, will be tested:
H01. RMPs are not determined by URRM, RI, RAA, RMON and CRA.
H02. There is no significant difference between conventional and Islamic bankswith respect to URRM, RI, RAA, RMON, CRA, RMPs and level of risk.
3. Methodology3.1 The instrumentA modified version of the questionnaire developed by Al-Tamimi and Al-Mazrooei(2007) and Hassan (2009) is used to collect the data for this study. It is divided into threeparts: Part I solicits information about the respondents and the bank for which theywork; Part II covers six aspects of risk management:
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(1) URRM;
(2) RI;
(3) RAA;
(4) RMON;
(5) RMPs; and
(6) CRA.
This part includes 51 statements to which respondents are invited to indicate theirlevel of agreement based on an interval scale, where 11 statements correspond toURRM; five, to RI; seven, to RAA; five, to RMON, 15, to RMPs and eight, to CRA.Respondents were asked to indicate the extent of their agreement with each of thequestions on a seven-point Likert scale. Part III consists of two closed questions basedon an ordinal scale dealing with the risks facing the sample banks and based on binaryanswers about the methods of RI used.
3.2 SampleIn the new banking environment, risk management is not restricted to theresponsibility of the risk management department, but is the responsibility of everyoneworking for the bank (KPMG International, 2009). According to KPMG International(2009), bank staff should understand the organizational risk appetite, and the riskmanagement system of checks and balances should incorporate three independentlayers of defense against risk: business units, risk management function and internalaudit. Therefore, the target population for the survey is not limited to riskmanagement specialists but extends to include all staff. Furthermore, the population issimilar to that used in the studies of Al-Tamimi and Al-Mazrooei (2007) andHassan (2009).
Banks operating in Bahrain were assigned to students in the Islamic Finance coursein the first semester of 2009/2010. Before approaching the assigned banks, students weretrained to administer the questionnaire. To maintain records of the questionnaires,students were asked to deposit the returned completed questionnaires soon afterreceiving them. Of 700 questionnaires distributed, 560 were returned. In total,26 questionnaires were excluded because of missing data. The resulting response ratewas 74.9 percent. Although the response is considered very high, testing was conductedfor the possibility of non-response bias.
Evidence of non-response bias was obtained by examining differences between theresponses of 30 early and late 30 respondents. The comparison indicated that therewere no significant differences between the two groups in terms of their responses tothe questions in the questionnaire.
To assess the reliability of the instrument, Cronbachs a was employed on the sixaspects of risk management included in the questionnaire. This measure consists ofestimates of how much variation in scores of different variables is attributable to chanceor random errors (Selltiz et al., 1976). As a general rule, a coefficient greater than or equalto 0.7 is considered acceptable and a good indication of construct reliability (Nunnally,1978). The internal consistency measured by Cronbachs a ranges between 0.713 for RIto 0.892 for URRM, indicating that the results are reliable. It is worth noting that allvalues of Cronbachs a reported by Al-Tamimi and Al-Mazrooei (2007)
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and Hassan (2009) are below 0.7. This indicates that construct reliability is better for theresults of the current study.
The characteristics of the respondents are shown in Table II. The questionnaireswere answered primarily by bankers occupying middle management positions or above,and the majority of the respondents (77.5 percent) possess experience of five years orlonger. All respondents held an academic and/or a professional qualification such asChartered Financial Analyst, Certified Public Accountant or Financial RiskManagement. Of the respondents, 52.5 percent work in conventional banks, while therest work in Islamic banks. The majority of the respondents (75 percent) work for locallyincorporated banks. Overall, we can conclude that those who took part in the surveyhave adequate knowledge about RMPs operating in their banks. In order to obtain ameasure of response reliability, interviews (lasting between 45 minutes and 1 hour)
Attributes Frequency %
GenderFemale 209 39.9Male 315 60.1Length of experienceLess than five years 205 39.1Five years and less than ten years 201 38.4Ten years or longer 118 22.5PositionExecutive/managerial 124 23.7Middle management 171 32.6Other 229 43.7Type of jobAudit 60 11.5Credit 66 12.6Finance 116 22.1Investment 63 12.0IT 27 5.2Operations 64 12.2Private banking 32 6.1Risk 48 9.2Treasury 44 8.4Other 4 0.8Highest qualificationBSc 312 59.5Professional (accounting, finance) 123 23.5Graduate degree 60 11.5Risk management professional qualification 16 3.1Other 13 2.5Type of licenseRetail conventional 175 33.4Retail Islamic 166 31.7Wholesale conventional 100 19.1Wholesale Islamic 83 15.8Type of bankLocally incorporated 393 75.0Foreign bank 131 25.0
Table II.Characteristics
of the sample
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were conducted with four randomly selected respondents approximately six monthsafter the questionnaires were received. No inconsistencies were found between thequestionnaire responses and the interview findings.
4. Analysis of the results4.1 Understanding risk and risk managementAppreciation of banks risk exposure by board members, executive management andother employees are of extreme importance for effective risk management. In addition,banks in Bahrain are required to comply strictly with the requirements pertaining tomanaging risk exposure set out in the rule book published by the Central Bank ofBahrain (CBB), the bank regulator. The CBB is known to be very prudent; and as aresult, one would expect banks in Bahrain to comply strictly with the rules. The rolesof banking regulators are more important as a result of the implementation of the BaselII Accord and the recent global financial crisis. To capture the URRM aspect of riskmanagement, 11 statements are included in the questionnaire. The summaries of theresponses are presented in Table III. The mean responses of all groups to thestatements range between 4.95 and 5.78, with an overall average of 5.34. The highestmean is for the statement, Managing risk is important to the performance and successof the bank. The lowest mean is for the statement, It is crucial to apply the mostsophisticated techniques in risk management; followed by The bank aims is toextend the application of advanced risk management techniques. This indicates thatbankers do not perceive those techniques to improve significantly the way risks aremanaged and/or those techniques are not understood well by those staff. Overall, theseresults indicate that staffs of banks operating in Bahrain have a good understanding ofrisk and risk management, which gives an indication of the ability of these banks tomanage risk efficiently in the future. These results are qualitatively similar to thosereported by Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009).
The sample is divided into two groups: those working for conventional banks andthose working for Islamic banks. This makes it possible to compare the perceptions ofthe two groups. Table III presents the summary of the responses. The mean responsesof Islamic bankers to all statements exceed the mean responses of the other group. Thetest statistics indicate that the mean responses of the two groups to the statements arenot significantly different, with the exception of four statements.
4.2 Risk identificationRI is the first step in managing risk by banks. Failure to identify risk makes itimpossible to manage. To capture the RI function performed by banks, thequestionnaire includes five questions. Table IV provides the results of means andstandard deviations for the answers to the five statements for all respondents and forthe two subgroups. The average of the means is 4.876, which indicates that banksoperating in Bahrain clearly identify the potential risk relating to their declared aimsand objectives. The mean responses of all questions exceed the midpoint (i.e. 4) on theseven-point Likert scale. This result is also consistent with the conclusion regardingunderstanding risk, as the more staff understand risk, the easier they can identify risk.Furthermore, this result for RI is consistent with those reported by Al-Tamimi andAl-Mazrooei (2007) and Hassan (2009). The t-statistics indicate that the mean responsesof conventional and Islamic bankers do not significantly differ from each other,
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Fre
qu
ency
of5-
7%
Mea
nS
Da
Mea
nS
DM
ean
SD
No.
Qu
esti
ons
Wh
ole
sam
ple
Con
ven
tion
alIs
lam
ict
b
1.T
her
eis
aco
mm
onu
nd
erst
and
ing
ofri
skm
anag
emen
tac
ross
the
ban
k37
972
.65.
421.
537
5.32
1.51
25.
521.
561
21.
482
2.R
esp
onsi
bil
ity
for
risk
man
agem
ent
iscl
earl
yse
tou
tan
du
nd
erst
ood
thro
ug
hou
tth
eb
ank
386
73.8
5.29
1.58
25.
251.
589
5.33
1.57
52
0.54
9
3.A
ccou
nta
bil
ity
for
risk
man
agem
ent
iscl
earl
yse
tou
tan
du
nd
erst
ood
thro
ug
hou
tth
eb
ank
397
75.9
5.37
1.48
95.
331.
513
5.42
1.46
52
0.64
7
4.M
anag
ing
risk
isim
por
tan
tto
the
per
form
ance
and
succ
ess
ofth
eb
ank
437
83.4
5.78
1.54
15.
681.
568
5.89
1.50
72
1.51
5
5.It
iscr
uci
alto
app
lyth
em
ost
sop
his
tica
ted
tech
niq
ues
inri
skm
anag
emen
t34
466
.34.
951.
503
4.77
1.54
35.
151.
434
22.
873
*
6.T
he
ban
kai
ms
toex
ten
dth
eap
pli
cati
onof
adv
ance
dri
skm
anag
emen
tte
chn
iqu
es35
567
.75.
051.
666
4.89
1.78
75.
231.
505
22.
349
*
7.It
isim
por
tan
tfo
rm
yb
ank
toem
ph
asiz
eco
nti
nu
ous
rev
iew
and
eval
uat
ion
ofth
ete
chn
iqu
esu
sed
inri
skm
anag
emen
t
402
76.7
5.43
1.63
95.
251.
755
5.62
1.47
92
2.60
0*
8.A
pp
lica
tion
sof
risk
man
agem
ent
tech
niq
ues
red
uce
cost
sor
exp
ecte
dlo
sses
414
79.3
5.53
1.52
95.
511.
524
5.46
1.43
92
0.45
7
9.S
tres
ste
stin
gou
tpu
tis
un
der
stoo
db
yse
nio
rm
anag
emen
tan
db
oard
395
75.7
5.38
1.53
05.
371.
524
5.39
1.53
92
0.16
2
10.
My
ban
kh
asan
effe
ctiv
eri
skm
anag
emen
tst
rate
gy
inp
lace
385
73.4
5.15
1.53
04.
961.
613
5.37
1.40
52
3.09
2*
11.
My
ban
kh
asan
effe
ctiv
eri
skm
anag
emen
tfr
amew
ork
(in
fras
tru
ctu
re,
pro
cess
and
pol
icie
s)in
pla
ce
392
75.0
5.34
1.57
35.
241.
681
5.46
1.43
92
1.83
9*
*
Av
erag
e5.
311.
074
5.21
1.13
55.
430.
988
22.
401
*
Notes:
Sig
nifi
can
tat
:* 5
and
** 1
0p
erce
nt;
aS
D
stan
dar
dd
evia
tion
;bt-
stat
isti
cs
Table III.Responses to statements
about URRM
Riskmanagement
practices
223
-
Fre
qu
ency
of5-
7%
Mea
nS
Da
Mea
nS
DM
ean
SD
No.
Qu
esti
ons
Wh
ole
sam
ple
Con
ven
tion
alIs
lam
ict
b
1.T
he
ba
nk
carr
ies
ou
ta
com
pre
hen
siv
ea
nd
syst
emat
icid
enti
fica
tion
ofit
sri
skre
lati
ng
toea
chof
its
dec
lare
dai
ms
and
obje
ctiv
es
381
73.1
5.14
1.45
15.
071.
476
5.22
1.42
12
1.24
2
2.T
he
ban
kfi
nd
sit
dif
ficu
ltto
iden
tify
,an
dcl
assi
fyit
sm
ain
risk
s26
450
.44.
131.
832
4.31
1.80
93.
941.
843
2.20
1*
3.C
han
ges
inri
skar
ere
cog
niz
edan
did
enti
fied
by
the
ban
ks
rule
san
dre
spon
sib
ilit
ies
363
69.3
5.05
1.47
95.
101.
566
5.00
1.37
70.
764
4.T
he
ban
kis
awar
eof
the
stre
ng
ths
and
wea
kn
esse
sof
the
risk
man
agem
ent
syst
ems
ofot
her
ban
ks
357
68.1
5.09
1.68
95.
011.
702
5.18
1.67
32
1.14
7
5.M
yb
ank
has
dev
elop
edan
dap
pli
edp
roce
du
res
for
the
syst
ema
tic
iden
tifi
cati
on
of
inv
estm
ent
opp
ortu
nit
ies
360
69.0
4.97
1.56
94.
971.
642
4.97
1.48
82
0.07
Av
erag
e4.
881.
051
4.89
91.
090
4.87
1.00
70.
222
Notes:
Sig
nifi
can
tat
:* 5
per
cen
t;aS
D
stan
dar
dd
evia
tion
;bt-
stat
isti
cs
Table IV.Responses to statementsabout RI
JRF13,3
224
-
with one exception as shown in Table IV. Like the results reported by Al-Tamimi andAl-Mazrooei (2007) and Hassan (2009), these results indicate that banks do not find itdifficult to identify and classify the main risk they face. However, the conventionalbanks in Bahrain appear to face more difficulties in prioritizing their main riskscompared with Islamic banks.
Respondents were asked to state whether or not their banks use the RI methodsincluded in the questionnaire. Table V depicts the frequency and the percentage of theresponses that indicate that they used the RI method. The entire sample ranked themethods inspection by the bank risk staff, audit and physical inspection and financialstatement analysis as the three methods most widely used to identify types of risks.Although both Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009) report a similarranking, their results indicate that more than 90 percent of the respondents indicate theuse of these methods, while the results of the current study indicate that none of themethods is used by 90 percent of the banks. The least used method is SWOT analysis,with only 61.7 percent of all respondents indicating their banks use this method.Similar results are found for the subgroups from conventional and Islamic banks.Overall, the results show that conventional and Islamic banks in Bahrain use moretraditional methods of RI than sophisticated methods.
4.3 Risk assessment and analysisRisks are generally identified at both the individual entity and the fully consolidatedlevels of an institution on the basis of management policies. While most risks areidentifiable, not all are quantifiable. An example of an identifiable but unquantifiablerisk is legal risk. The next step in risk management, after RI, is to assess and analyzethe identified risks. The mean responses of the entire sample to the seven componentsincluded in the questionnaire to capture this aspect of risk management (Table VI)
Frequencyyes
% Rank Frequencyyes
% Rank Frequencyyes
%Rank
No. Questions Whole sample Conventional Islamic
1. Inspection by thebank risk staff
426 81.3 1 232 84.2 1 194 77.9 2
2. Audit and physicalinspection
419 80.0 2 220 80.0 2 199 79.9 1
3. Financial statementanalysis
402 77.2 3 211 58.4 8 191 76.7 3
4. Risk survey 321 62.0 8 157 57.1 9 164 65.9 95. Process analysis 386 74.4 4 199 72.4 3 187 75.4 46. SWOT analysis 318 61.7 9 169 61.5 7 149 59.8 107. Inspection by
Shariaa auditors(Islamic banks only)
N/A N/A 178 71.5 5
8. Benchmarking 342 66.3 7 177 64.4 6 165 66.3 89. Scenario analysis 353 68.1 6 185 67.3 5 168 67.5 7
10. Internalcommunication
362 69.7 5 191 69.5 4 171 68.7 6
Note: N/A not applicable
Table V.Responses regarding
RI methods
Riskmanagement
practices
225
-
Fre
qu
ency
of5-
7%
Mea
nS
Da
Mea
nS
DM
ean
SD
No.
Qu
esti
ons
Wh
ole
sam
ple
Con
ven
tion
alIs
lam
ict
b
1.M
yb
ank
asse
sses
the
lik
elih
ood
ofri
skoc
curr
ing
397
76.1
5.21
1.36
25.
191.
376
5.23
1.35
02
0.29
12.
Th
eb
ank
sri
skis
asse
ssed
by
usi
ng
qu
anti
tati
ve
anal
ysi
sm
eth
ods
378
72.3
5.16
1.50
75.
101.
556
5.22
1.45
12
0.86
9
3.T
he
ban
ks
risk
isas
sess
edb
yu
sin
gq
ual
itat
ive
anal
ysi
sm
eth
ods
(e.g
.h
igh
,m
oder
ate
and
low
)40
076
.55.
351.
529
5.27
1.55
25.
441.
502
21.
273
4.M
yb
ank
sre
spon
seto
anal
yzi
ng
risk
incl
ud
esas
sess
men
tof
the
cost
san
db
enefi
tsof
add
ress
ing
risk
400
76.3
5.19
1.49
65.
121.
483
5.27
1.50
92
1.16
7
5.M
yb
ank
sre
spon
seto
anal
yzi
ng
risk
incl
ud
esid
enti
fyin
g,
pri
orit
izin
gof
risk
and
sele
ctin
gth
ose
that
nee
dac
tiv
em
anag
emen
t
406
77.5
5.37
1.56
95.
361.
558
5.38
1.58
42
0.12
7
6.M
yb
ank
sre
spon
seto
anal
yzi
ng
risk
incl
ud
esid
enti
fyin
g,
pri
orit
izin
gri
sktr
eatm
ents
wh
ere
ther
ear
ere
sou
rce
con
stra
ints
onri
sktr
eatm
ent
imp
lem
enta
tion
398
76.1
5.36
1.50
45.
231.
574
5.51
1.41
22
2.12
3*
7.M
yb
ank
reli
eson
the
outp
ut
ofq
uan
tita
tiv
ed
ata
wit
hou
th
um
anju
dg
men
t30
057
.34.
511.
671
4.50
1.60
14.
511.
749
20.
084
Av
erag
e5.
161.
065
5.10
1.11
35.
221.
001
20.
208
Notes:
Sig
nifi
can
tat
:* 5
per
cen
t;aS
D
stan
dar
dd
evia
tion
;bt-
stat
isti
cs
Table VI.Responses to statementsabout RAA
JRF13,3
226
-
range between 4.51 and 5.37 with an average of 5.16. The lowest mean response is tothe statement My bank relies on the output of quantitative data without humanjudgment. This indicates that banks give important consideration to human judgmentas well as quantitative analysis. Overall, the results indicate that banks in Bahrain areefficient in assessing and analyzing risk. These results are qualitatively similar tothose reported by Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009).
Table V summarizes the responses of conventional and Islamic bankers whichindicate that the mean responses to the seven statements by Islamic bankers are higherthan those of their conventional counterparts. To test the hypothesis that the meanresponses of the samples are not significantly different, t-statistics were used. Theresults show that the mean responses of the groups to the statements are notsignificantly different, with the exception of My banks response to analyzing riskincludes identifying, prioritizing risk treatments where there are resource constraints onrisk treatment implementation.
4.4 Risk monitoringThe primary components of risk management are internal controls and managementinformation systems for controlling, monitoring and reporting risks. RMON aims todetermine whether the risk exposures are in line with the desired level and are dealt withproperly. To capture this aspect of risk management, five statements are included in thequestionnaire. Table VII reports the responses of the whole sample, conventionalbankers and Islamic bankers. The mean responses to the five statements range between5.16 and 5.41, with an overall average of 5.29. These results indicate that bankers believethat banks operating in Bahrain have efficient RMON and control system.
The mean of the responses of conventional bankers is lower than that of Islamicbankers. The mean responses of Islamic bankers on the five components of the RI aspectof risk management are higher than those of conventional bankers. To test the hypothesisthat the mean responses of conventional and Islamic bankers are not significantlydifferent from each other, we used the t-test. The results of the test are shown in Table VII.They indicate that there are no significant differences between the mean responses of thegroups, with the exception of the mean responses to the statement Reporting andcommunication processes within my bank support the effective management of risk.
4.5 Risk management practicesBanks boards and staff understanding of the risks faced and having effective riskmanagement strategies and frameworks (infrastructure, process and policies) in placedo not guarantee that banks manage their risk exposure effectively. The gap betweenwhat is expected from bank staff and RMP is one of the reasons for banking failure. Intotal, 15 statements are included in the questionnaire to capture the RMPs. Table VIIIsummarizes the responses to those statements. The overall mean response is 5.23, andmeans responses range between 4.38 and 5.51. The lowest mean response(very close to the midpoint of the Likert scale) was that of the statement Riskmanagement techniques are used for regulatory purposes only. These results lendfurther support to the responses to the statements that capture URRM, in which therespondents agreed that effective risk management improves banks performances.These results also indicate that the banks staffs are aware of the application of the BaselCapital Accord, which was introduced to improve the efficiency of banks riskmanagement.
Riskmanagement
practices
227
-
Fre
qu
ency
of5-
7%
Mea
nS
Da
Mea
nS
DM
ean
SD
No.
Qu
esti
ons
Wh
ole
sam
ple
Con
ven
tion
alIs
lam
ict
b
1.M
onit
orin
gth
eef
fect
iven
ess
ofri
skm
anag
emen
tis
anin
teg
ral
par
tof
rou
tin
em
anag
emen
tre
por
tin
g38
473
.35.
161.
450
5.14
1.46
35.
191.
438
20.
432
2.L
evel
ofco
ntr
olb
yth
eb
ank
isap
pro
pri
ate
for
the
risk
that
itfa
ces
403
76.9
5.39
1.55
05.
201.
623
5.60
1.43
92
2.97
7*
3.R
epor
tin
gan
dco
mm
un
icat
ion
pro
cess
esw
ith
inm
yb
ank
sup
por
tth
eef
fect
ive
man
agem
ent
ofri
sk39
575
.45.
241.
602
5.16
1.68
85.
341.
500
21.
273
4.T
he
ban
ks
resp
onse
tori
skin
clu
des
anev
alu
atio
nof
the
effe
ctiv
enes
sof
the
exis
tin
gco
ntr
ols
and
risk
man
agem
ent
resp
onse
s
403
76.9
5.41
1.57
45.
381.
633
5.44
1.51
02
0.43
2
5.T
he
ban
ks
resp
onse
tori
skin
clu
des
acti
onp
lan
sin
imp
lem
enta
tion
dec
isio
ns
abou
tid
enti
fied
risk
406
77.8
5.26
1.47
85.
211.
526
5.32
1.42
32
0.87
2
Av
erag
e5.
291.
210
5.21
1.27
45.
371.
133
21.
813
**
Notes:
Sig
nifi
can
tat
:* 5
and
** 1
0p
erce
nt;
aS
D
stan
dar
dd
evia
tion
;bt-
stat
isti
cs
Table VII.Responses to statementsabout RMON
JRF13,3
228
-
Fre
qu
ency
of5-
7%
Mea
nS
Da
Mea
nS
DM
ean
SD
No.
Qu
esti
ons
Wh
ole
sam
ple
Con
ven
tion
alIs
lam
ict
b
1.T
he
ban
ks
exec
uti
ve
man
agem
ent
reg
ula
rly
rev
iew
sth
eor
gan
izat
ion
sp
erfo
rman
cein
man
agin
git
sb
usi
nes
sri
sk
402
76.7
5.40
1.55
15.
391.
613
5.41
1.48
12
0.07
0
2.M
yb
ank
ish
igh
lyef
fect
ive
inco
nti
nu
ous
rev
iew
/fe
edb
ack
onri
skm
anag
emen
tst
rate
gie
san
dp
erfo
rman
ce
400
76.3
5.32
1.54
85.
321.
595
5.32
1.49
82
0.03
6
3.M
yb
ank
sri
skm
anag
emen
tp
roce
du
res
and
pro
cess
esar
ed
ocu
men
ted
and
pro
vid
eg
uid
ance
tost
aff
abou
tm
anag
ing
risk
s
402
76.7
5.36
1.60
65.
311.
721
5.42
1.47
12
0.75
2
4.M
yb
ank
sp
olic
yen
cou
rag
estr
ain
ing
pro
gra
ms
inth
ear
eari
skm
anag
emen
tas
wel
las
eth
ics
365
69.7
5.02
1.66
34.
911.
748
5.16
1.55
72
1.73
0
5.M
yb
ank
emp
has
izes
the
recr
uit
men
tof
hig
hly
qu
alifi
edp
eop
lew
ho
hav
ek
now
led
ge
ofri
skm
anag
emen
tp
erta
inin
gto
the
typ
eof
the
ban
k
374
71.4
5.06
1.72
24.
921.
704
5.20
1.73
32
1.87
1
6.E
ffec
tiv
eri
skm
anag
emen
tis
one
ofth
eob
ject
ives
ofm
yb
ank
418
79.8
5.47
1.47
05.
371.
500
5.57
1.43
22
1.58
4
7.It
isto
ori
sky
toin
ves
tm
yb
ank
sfu
nd
sin
one
spec
ific
sect
orof
the
econ
omy
415
79.3
5.51
1.59
45.
371.
705
5.66
1.45
12
2.20
8*
8.T
he
app
lica
tion
ofB
asel
Acc
ord
IIim
pro
ved
ofef
fici
ency
and
RM
Ps
inm
yb
ank
inp
arti
cula
r40
578
.25.
491.
433
5.40
1.49
95.
601.
350
21.
562
9.M
yb
ank
sca
pit
alis
adeq
uat
eif
the
rati
oof
cap
ital
toto
talr
isk
-wei
gh
ted
asse
tsis
equ
alto
the
CA
Rp
resc
rib
edb
yth
eC
BB
356
69.7
5.12
1.35
95.
101.
386
5.15
1.33
12
0.39
1
10.
Ico
nsi
der
the
lev
elof
RM
Ps
inm
yb
ank
tob
eex
cell
ent
380
73.8
5.16
1.44
85.
051.
575
5.28
1.28
32
2.02
6*
11.
Ris
km
anag
emen
tis
giv
eng
reat
imp
orta
nce
by
my
ban
k41
178
.65.
501.
616
5.31
1.78
05.
691.
389
22.
741
*
12.
Sen
ior
man
agem
ent
lead
risk
man
agem
ent
from
the
top
401
77.5
5.37
1.65
45.
271.
770
5.48
1.51
12
1.44
813
.R
isk
fact
ors
are
con
soli
dat
edac
ross
allb
ank
sop
erat
ion
s31
260
.04.
931.
483
4.76
1.50
55.
101.
442
22.
655
*
14.
Ris
km
anag
emen
tte
chn
iqu
esar
eu
sed
asm
anag
emen
tto
ols
399
76.4
5.32
1.47
75.
261.
527
5.39
1.41
92
1.00
1
15.
Ris
km
anag
emen
tte
chn
iqu
esar
eu
sed
for
reg
ula
tory
pu
rpos
eson
ly28
354
.04.
381.
757
4.50
1.75
04.
241.
759
1.72
6
Av
erag
e5.
541.
085
5.46
1.20
05.
640.
934
21.
978
*
Notes:
Sig
nifi
can
tat
:* 5
and
** 1
0p
erce
nt;
aS
D
stan
dar
dd
evia
tion
;bt-
stat
isti
cs
Table VIII.Responses to statements
about RMPs
Riskmanagement
practices
229
-
The responses of those working in conventional and Islamic banks are shown inTable VIII. With the exception of the mean response to the statement Riskmanagement techniques are used for regulatory purposes only, the means responsesto the statements by Islamic bankers are higher than those of the conventional bankers.The t-statistics indicate that the differences between the mean scores of the two groupsare not significantly different from zero, with three exceptions.
4.6 Credit risk assessmentBanks face different types of risk. However, credit risk is the most significant of thoserisks. This is evident in the calculation of the capital adequacy ratio according to Basel IIrequirements. For this reason, eight statements are included in the questionnaire tocapture the perception of the respondents of this risk. Table IX reports the samplesresponses on these questions. The mean of the responses to the eight questions is 5.34,which provides evidence about the efficiency of credit risk management by the Bahrainibanking industry. For the whole sample, the most important aspect is the risk rating ofapplicants, followed by the specific analysis of the applicants character, capacity,collateral and conditions. The need for applicants to provide sufficient collateral isconsidered, based on the mean of the responses, the fifth most important aspects of CRA.Requiring applicants to adhere to certain covenants as pre-conditions for granting creditor executing transactions came in seventh place with a mean response rate of 5.35.Responses to the eight statements range between 5.04 and 5.56. The mean responses toall questions of respondents working in Islamic banks are higher than those of theirconventional counterparts, but only two are significantly different.
4.7 Types of risksBanks are exposed to different types of risks. The importance of those types depends onthe asset portfolio, the way they conduct their business lines (i.e. conventional orIslamic), and regulatory requirements to which banks are subjected. To identify theimportance of the types of risks to which banks are exposed, respondents were asked tostate their perceptions of the level of importance of 15 different types of risks on aseven-point Likert scale ranging from very important (7) to not important at all (1).Table X presents a summary of the responses and the t-statistics to test the hypothesisthat the mean responses of the conventional and Islamic bankers do not differsignificantly. The types of risk are shown in terms of relative importance based on themean responses of the whole sample. As shown in Table X, the mean responses for alltypes of risk, with the exception of residual risk, are higher than 5. The results show thatthe most important risk banks face is credit risk. This type of risk has long beenidentified as the dominant risk for banking firms and is an inherent part of their corelending business. Credit extended to customers and customers deposits generallyrepresents the most significant asset and liability classes on a banks balance sheet.Liquidity risk is ranked the second most important risk, while it is ranked fourth in thestudy of Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009). The difference inranking is probably due to the period during which the data for the study was collected,which was a year after the beginning of the global financial crisis; the liquidity crunchwas central to that crisis. Operational risk is ranked third by the respondents. This risk isdefined as the risk of direct or indirect loss resulting from inadequate or failed internalprocesses, people and systems or from external events. The level of importance of this
JRF13,3
230
-
Fre
qu
ency
of5-
7%
Mea
nS
Da
Mea
nS
DM
ean
SD
No.
Qu
esti
ons
Wh
ole
sam
ple
Con
ven
tion
alIs
lam
ict
b
1M
yb
ank
un
der
tak
esa
cred
itw
orth
ines
san
aly
sis
bef
ore
gra
nti
ng
cred
itor
exec
uti
ng
tran
sact
ion
s42
180
.35.
331.
383
5.25
1.41
15.
431.
348
21.
449
2B
efor
eg
ran
tin
gca
pit
alor
cred
itm
yb
ank
un
der
tak
essp
ecifi
can
aly
sis
incl
ud
ing
the
app
lica
nt
sch
arac
ter,
cap
acit
y,
coll
ater
alan
dco
nd
itio
ns
395
75.7
5.44
1.57
55.
221.
797
5.67
1.20
42
2.29
8*
3M
yb
ank
sb
orro
wer
sar
ecl
assi
fied
acco
rdin
gto
risk
fact
ors
(ris
kra
tin
g)
411
78.7
5.56
1.53
25.
291.
681
5.60
1.43
32
2.40
5*
4It
ises
sen
tial
tore
qu
ire
suffi
cien
tco
llat
eral
from
smal
lb
orro
wer
s39
375
.65.
341.
495
5.26
1.59
35.
421.
376
21.
197
5M
yb
ank
sp
olic
yre
qu
ires
coll
ater
alfo
rg
ran
tin
gca
pit
al,
exte
nd
ing
cred
it,
orm
akin
gtr
ansa
ctio
ns
412
78.9
5.37
1.46
55.
341.
559
5.41
1.33
52
0.58
6
6It
isp
refe
rab
leto
req
uir
eco
llat
eral
agai
nst
som
eca
pit
alan
dn
otal
lof
it36
670
.15.
041.
548
4.99
1.62
85.
111.
454
20.
918
7T
he
lev
elof
cap
ital
(cre
dit
)g
ran
ted
tod
efau
ltin
gcl
ien
tsm
ust
be
red
uce
d40
477
.85.
341.
549
5.33
1.63
45.
351.
451
20.
090
8T
he
ban
kre
qu
ires
app
lica
nts
toad
her
eto
cert
ain
cov
enan
tsas
pre
-con
dit
ion
sfo
rg
ran
tin
gcr
edit
orex
ecu
tin
gtr
ansa
ctio
ns
411
78.7
5.32
1.45
55.
271.
528
5.39
1.36
82
0.96
6
Av
erag
e5.
451.
142
5.27
1.11
85.
430.
855
22.
218
*
Notes:
Sig
nifi
can
tat
* 5an
d*
* 10
per
cen
t;aS
D
stan
dar
dd
evia
tion
;bt-
stat
isti
cs
Table IX.Responses to statements
addressing CRA
Riskmanagement
practices
231
-
Fre
qu
ency
of5-
7%
Mea
nS
Da
Mea
nS
DM
ean
SD
Qu
esti
ons
Wh
ole
sam
ple
Con
ven
tion
alIs
lam
ict
b
1.C
red
itri
sk44
685
.16.
011.
566
5.94
1.60
06.
091.
528
21.
099
2.L
iqu
idit
yri
sk44
184
.25.
911.
604
5.80
1.64
16.
041.
555
21.
715
**
3.O
per
atin
gri
sk42
881
.75.
781.
594
5.64
1.70
65.
921.
452
2.03
0*
4.L
egal
risk
418
79.8
5.72
1.62
55.
611.
704
5.84
1.52
62
1.64
55.
Reg
ula
tory
risk
412
78.6
5.58
1.50
45.
491.
541
5.68
1.46
02
1.42
96.
Rep
uta
tion
risk
402
76.7
5.52
1.59
25.
431.
593
5.61
1.58
82
1.30
37.
Str
ateg
icri
sk39
775
.95.
471.
675.
421.
689
5.52
1.65
12
0.72
58.
Sol
ven
cyri
sk39
976
.65.
391.
613
5.26
1.70
55.
531.
495
21.
015
9.In
tere
stra
teri
sk(c
onv
enti
onal
ban
ks
only
)21
3c77
.55.
311.
524
5.31
1.52
4N
otap
pli
cab
le10
.R
ate
ofre
turn
risk
(Isl
amic
ban
ks
only
)18
8d75
.55.
481.
476
Not
app
lica
ble
5.48
1.47
611
.S
ettl
emen
tri
sk38
172
.85.
391.
592
5.24
1.63
5.55
1.53
72
2.29
1*
12.
Con
cen
trat
ion
risk
407
77.8
5.31
1.36
65.
231.
387
5.39
1.33
92
1.32
613
.P
rice
(eq
uit
y)
risk
387
74.1
5.30
1.53
45.
211.
554
5.41
1.50
92
1.55
314
.F
orei
gn
-ex
chan
ge
risk
391
74.6
5.28
1.58
35.
261.
644
5.31
1.51
52
0.39
715
.C
oun
try
(pol
itic
al)
risk
379
72.6
5.23
1.55
65.
081.
615
5.38
1.47
42
2.21
5*
16.
Res
idu
alri
sk28
858
.34.
761.
666
4.51
1.83
65.
041.
406
23.
643
*
Av
erag
e5.
421.
135
5.34
1.20
25.
571.
062
22.
256
*
Notes:
Sig
nifi
can
tat
:* 5
and
** 1
0p
erce
nt;
aS
D
stan
dar
dd
evia
tion
;bt-
stat
isti
cs;
c ou
tof
275
resp
ond
ents
;dou
tof
349
resp
ond
ents
Table X.Risk faced byconventional andIslamic banks
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risk stems from the fact that it is part of the capital adequacy ratio calculatedin accordance with the requirements of Basel II. Operational risk includes legal andregulatory risks which the respondents ranked third and fourth, respectively.Foreign-exchange risk, unlike the results of Hassan (2009) which ranked this as the mostimportant risk, was ranked 13th by the respondents. The low ranking of the foreignexchange risk by the sample is probably due to the fact that the Bahraini dinar is fixedagainst the US dollar. Furthermore, the banks assets in foreign countries do not use theUS dollar or their currencies do not have a fixed rate against the US dollar as ofthe August 2011; this represents 20.7 percent of the retail banking assets according to theCBB (2011).
Those working in conventional and Islamic banks reported and ranked similarly thesame top six types of risk: credit, liquidity, operational, legal, regulatory andreputational. These results are somewhat similar to those reported by Ariffin et al. (2009);they found that Islamic bankers perceived credit risk as the most important. However,those findings contradict Khan and Ahmed (2001), Al-Tamimi and Al-Mazrooei (2007)and Hassan (2009). The mean responses of all types of risk exceed 5, with the exception ofthe mean responses of residual risk by bankers in conventional banks. The meanresponses of the types of risks included in the questionnaire by the Islamic bankersexceed those of conventional bankers.
The t-test is used to test the hypothesis that the samples perceived the level ofimportance of the types of risk similarly. According to the results, the overall risk levelfacing Islamic banks is perceived to be significantly higher than that faced byconventional banks. Furthermore, the t-statistics indicate that there are no significantdifferences between the mean responses of the two groups, with the exception ofliquidity, operational, settlement, country (political) and residual risks. With those typesof risks, it is found that Islamic banks face significantly higher risks than theirconventional counterparts. The higher liquidity risk faced by Islamic banks may be theresult of:
. a lack of active money markets for Islamic Shariaa compliant money marketinstruments;
. restricted access to short-term financing options that are available forconventional banks, including such funding from the CBB; and
. maintaining high cash balances out of the balance of current accounts held tocover clients demands for withdrawals from their accounts (Iqbal and Mirakhor,2011).
As for higher operational risk facing Islamic banks, this is due partly to a unique typeof risk facing Islamic banks; namely, Shariaa risk, which is a part of operational risk.This unique risk is due to the need to make their products Shariaa-compliant. Unlikeconventional bank products, products of Islamic banks lack standardization. In orderto ensure that their products are Shariaa-compliant, Islamic banks should obtain theapproval of their respective Shariaa supervisory boards. However, this approval maynot ensure acceptability of those products by other Shariaa supervisory boards ofother Islamic banks or clients. Another dimension of Shariaa risk is legal risk. Islamicbanking products can involve a number of separate contracts, giving rise to additionallegal risks. For example, in the case of murabahah[1] transactions, which representthe dominant investment of Islamic banks, the bank has to buy an item and then sell
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it under different payment terms. Each step takes time and involves a new contractualagreement, magnifying the scope for disagreements and complications. Shariaa riskmay lead to a loss of profit generated from non-Shariaa-compliant sources. Thesettlement risk to Islamic banks, as a form of credit risk, arises when an Islamic bankpays money such as salam[2] or istisna[3] contracts or delivers assets such asmurabahah contracts before receiving its own assets or cash, thereby exposing it topotential loss (Khan and Ahmed, 2001). Such practices make the level of settlement riskfaced by Islamic banks higher than that which faces conventional banks. The residualrisk is the risk that third party claims must be met first before the shareholders receiveany return on capital. Unlike conventional banks, which provide loans fully backed bythe borrowers assets and thus shift the entire risk to borrowers, some of financialproducts of Islamic banks, such as mudharaba[4] and musharakah[5], are structured ina way that Islamic banks share the risk of the asset with the clients (Ebrahim, 2000). Inaddition, Islamic banks, unlike conventional banks, have limited opportunity to chargeclients for the additional risks they face in case of delinquency and loan restructuring.Consequently, Islamic banks face higher residual risk compared with conventionalbanks.
The lack of significant differences between the types of banks regarding credit riskwarrants an explanation. Based on Islamic banking principles of risk sharing andprofit-and-loss sharing, it is expected that the credit risk facing Islamic banks should besignificantly higher than that of conventional banks. One of the most importantexplanations is that the murabahah is the dominant investment instrument of the assetportfolio of Islamic banks (Rosly, 2011), and profit-sharing financing, suchas mudharabah and musharakah has remained negligible in operations of Islamicbanks. As of August 2011, the latter represent not more than 6.12 percent of the assetsmanaged by Islamic banks in Bahrain (CBB, 2011). Although, theoretically, banks areexposed to business and credit risks when they enter into contracts of bankingmurabahah, in reality such contracts are considered to be akin to loans granted byconventional banks and as such are gross violations of Shariaa principles (Khan andBhatti, 2008). This is because Islamic banks:
. insure themselves against the risk of damage to goods, theft and destruction andlevy charges against the clients (Bashir, 1999), or make the necessaryarrangements with asset dealers or charge the client hamish jiddiyah (securitydeposit)[6] to eliminate business risks that they may be exposed to during theownership period before signing the murabahah contract with clients;
. use the market interest rate to determine the mark-up (interest rate) charged toclients;
. charge higher mark-up on murabahah contracts with longer terms, and highercredit risk; and
. use the market interest rate as a benchmark for setting the mark-up they chargeto clients (borrowers).
Overall, the unique risks facing Islamic banks lead them to face higher total riskcompared with conventional banks.
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4.8 Testing the hypotheses regarding RMPsThis paper examines the relationship between RMPs and the five aspects of the riskmanagement process (H01):
(1) URRM;
(2) RI;
(3) risk analysis and assessment;
(4) RMON; and
(5) CRA.
Following Al-Tamimi and Al-Mazrooei (2007), the function of RMPs is as follows:
RMPs f URRM; RAA; RI; RMON; CRA; bank typeUnlike Al-Tamimi and Al-Mazrooei (2007), a dummy variable is included in the modelto capture the possible effect of the type of bank (conventional or Islamic) on the RMPs.Table XI presents the regression results. The variance information factors of theindependent variables are less than 5 and tolerance of more than 0.215 indicates thatmulticolinearity does not pose a problem in interpreting these results (Kutner et al.,2003). Furthermore, the Durbin-Watson statistic of 2.005 indicates no seriousautocorrelation exists. The results show that the constant and coefficients of allindependent variables, including the dummy variable, have a positive sign. Also, thecoefficients of URRM, RAA, RI, RMON and CRA are significant at the 5 percent levelor less. The adjusted R 2 is 81.6 percent and highly significant. These results indicatethat the null hypothesis that states no effect of URRM, RAA, RI, RMON and CRAon RMPs is rejected. Our results are partially similar to those reported by Al-Tamimiand Al-Mazrooei (2007) and Hassan (2009) who found that only the coefficient of RI andRAA are significant. These differences may be attributed to the prudent and vibrantCBB which follows a risk-based supervision approach (IMF, 2006).
To test H02 the analysis of variance (ANOVA) was applied on each of the six aspectsof risk management and risks facing banks. The results are presented in Table XII.Using the 5 percent level of significance, the results indicate that there are no significantdifferences in any aspect of risk management between conventional and Islamic banks,with the exception of URRM and level of risk. This is an unexpected result, as both types
Variable Estimates SE Standardized b Tolerance VIF
Constant 0.175 0.135URRM 0.362 * 0.043 0.359 0.215 4.648RAA 0.205 * 0.035 0.200 0.338 2.958CRA 0.275 * 0.036 0.258 0.343 2.918RI 0.057 * 0.029 0.056 0.481 2.079RMON 0.118 * 0.033 0.131 0.289 3.459Banks type 0.024 0.043 0.011 0.973 1.028Adjusted R 2 (%) 81.6%F-statistics 353.569 *
Durbin-Watson 2.005
Note: Significant at: *5 percent or less
Table XI.Regression results:
dependent variable RMPs
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of bank are subject to the same regulatory requirements and a regulatory system thatmaintains closely aligned prudential regulations for both types of banks to guarantee asfar as possible a level playing field (IMF, 2006). However, Islamic banks are exposed toadditional types of risks that are unique to those banks, such as Shariaa risk, and somerisks arising from profit-sharing investment deposits (Khan and Ahmed, 2001;Ariffin et al., 2009). Additionally, the structure of some products of Islamic banks makethem share asset risks with their clients (borrowers). This explains the findings thatshow Islamic banks face higher risk than those of conventional banks because theconventional banks protect themselves by granting loans fully backed by the borrowersassets and thus shift the entire risk to the other party.
5. Conclusions, implications, limitations and further researchThe purpose of this paper is to report the results of an empirical study of the RMPs ofconventional and Islamic banks operating in Bahrain. A questionnaire was used toobtain the information needed to achieve the studys objectives. The main conclusionsof the study are:
. bankers in Bahrain are aware of the importance and the role of effective riskmanagement in reducing costs and improving bank performance;
. banks in Bahrain have in place effective risk strategies and effective riskmanagement frameworks (infrastructure, process and policies);
. the three most important types of risk facing banks operating in Bahrain arecredit risk, followed by liquidity and operating risk;
. banks are somewhat effective in assessing and analyzing risks, RMPs, RMONand RI;
. the quality of RMPs is determined by URRM, RI, RAA and CRA; and
. the RMPs, RI, RAA and CRA of Islamic banks do not differ significantly fromthose of conventional banks, although the types of banks differ significantlyfrom each other with respect to their URRM.
Overall the results show that Islamic banks face higher levels of risk than conventionalbanks. It is found that Islamic banks face higher liquidity, operational, settlement,country and residual risks than their conventional counterparts. These results areattributable to differences in the products of both types of banks that lead to uniquerisks to Islamic banks.
Aspect F-statistics Significant level
URRM 5.338 0.021 *
RI 3.083 0.080RAA 0.065 0.800CRA 1.227 0.268RMON 2.469 0.117RMPs 3.763 0.053Risk 5.025 0.025 *
Note: Significant at: *5 percent or less
Table XII.The results of ANOVAfor conventional banksand Islamic banks
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The results of the study have implications for clients, banks management, investorsand regulators. Depositors should know that they are facing higher risks when theydeal with Islamic banks, and they would therefore expect to receive a higher rate ofreturns. Also, borrowers are expected to pay a higher profit (interest) rate to Islamicbanks because those banks share the asset risk with them. However, competition withconventional banks may put them at a disadvantage, which reduces their ability tocharge a higher profit rate. As for management and regulators, knowledge of theunique types of risk facing each type of bank should lead to the development of specialrisk management techniques and monitoring procedures that are suitable for thoserisks, in addition to enhancing transparency. Finally, investors holding shares inIslamic banks are expected to hold stocks with relatively high unsystematic riskcompared with stocks of conventional banks. This is an important result for portfolioconstruction and management.
The results of this study should be interpreted in the light of a number oflimitations:
. the conditions facing banks in Bahrain during the period in which thequestionnaires were distributed might have affected some of the results,especially the type of risk facing the banking industry; and
. although the response rate is very high, there was no evidence of non-responsebias, and the responses were highly consistent internally, the study relies onsurvey methodology which measures the beliefs, but not necessarily the actions,of bankers.
Therefore, caution should be taken in generalizing the findings.In summary, additional research is recommended in order to further understanding
of RMPs of conventional and Islamic banks. This could be achieved by studying:. risk management techniques used to mitigate risk exposure;. the specific risks to which banks are exposed, such as liquidity, market (price)
and operational risk;. the role of boards of directors and regulators in enhancing RMPs; and. banks transparency with regard to risk management.
An important effect of Shariaa is that all investments are, in effect, backed by aphysical asset, and there cannot be pure speculation in money terms alone. This shouldhave substantial implications on the way Islamic banks handle their risks. Forexample, they should be much less highly geared than traditional banks and shouldnot be trading in options, which did so much to produce the recent economic andfinancial crisis. In the light of those considerations, it was very surprising thatemployees of Islamic banks and traditional banks should have such similar viewsabout some aspects of risk management. This could be another focus for futureresearch.
Notes
1. A form of financing, often used to finance asset purchases or for consumer loans orconventional trade finance. The bank buys the asset on a cash basis before selling it to theclient (borrower) on credit.
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2. A sales contract in which the price is paid in advance at the time of contracting againstdelivery of the purchased goods/services at a specified future date.
3. A form of sale in which a commodity is sold before it comes into existence.
4. Mudharabah is venture capital funding of an entrepreneur who provides labor whilefinancing is provided by the bank so that both profit and risk are shared.
5. In musharakah financing, the Islamic bank contributes the depositors funds to a jointenterprise with the client (an entrepreneur). Generally, clients manage all the affairs of amusharakah business, and they share the profit and loss made on the musharakahinvestment with the Islamic bank.
6. A certain amount of money taken from a customer who places an order to purchase as asecurity for his/her promise.
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About the authorsHameeda Abu Hussain is an Assistant Professor of Finance at the University of Bahrain. Herresearch interests are international finance, currencies, stock exchange markets, conventionaland Islamic banking. She teaches Corporate Finance, International Finance and InvestmentManagement. She was chairperson of the Department of Economics & Finance, Department ofOffice Management Department, and Dean of the College of Business Administration.
Jasim Al-Ajmi is a Professor of Finance and Corporate Governance at the University ofBahrain. He has worked in the banking industry and has published extensively in the areas ofcorporate governance, financial institutions, investors behavior, capital markets, riskmanagement, financial analysis, Islamic finance and behavioral finance. He served as a BoardMember of the Eskan (Housing) Bank, Chairman of the Remuneration Committee of the EskanBank, and member of the Audit Committee of the Eskan Bank. He is a board member of BahrainCompetitive Council and MENA-OECD Investment Center. He was a member of the NationalCommittee of Corporate Governance that drafted the unified corporate governance code.Jasim Al-Ajmi is the corresponding author and can be contacted at: [email protected]
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