gif Risk Management


Different products offered by Islamic banks have different collateral structures, that could permissibly be classified according to either category 1 or 3 above. The table below demonstrates which Islamic products would be suitable for which category:


The reason why Islamic products could not be classified according to the second catego- ry is because Islamic banks are not permit- ted by sharia’a law to have revolving credits. Despite the fact that some credit restructur- ing is allowed, indeed encouraged, in the event of customers facing genuine payment difficulties, these cannot be considered as revolving credits. In terms of classifying risk relevant to the broad, umbrella-like third cat- egory, it is a challenging process but Islamic banks should not be afraid to take the lead


Basel II: Available Approaches for Credit Risk


Credit risk is defined as the risk that a counterparty will default on one or more payments. three approaches


can be used to determine the required capital:


Standardized Approach Roughly the same as the current basel I approach, In additional to the standard risk weights currently available, clients need to be graded by an External Credit Assessment Institution (ECAL). The rating of the counterparty will be incorporated into the overal risk


weighting. Foundation Internal Ratings-Based Approach


(FIRB)


Banks do not rely on ECALs for their ratings, but deter- mine the probability of default (PD) of their borrowers using an internally built model. Loss-given (LGD) and exposure-at-default (EAD) are determined based on


supervisory rules defined in Basel II.


Advanced Internal Ratings Based (AIRB) Not only the PD, but also LGD and EAD are determined based on internally built models.


to describe risks associated with such credit relationships and to subsequently establish a risk weight foundation.


What of other Islamic finance instruments? Both mudaraba and musharaka could stand to benefit from the special treatment associ- ated with equity participation as handled by the IRB approach. The two different meth- ods for handling equity participation under IRB are:


• Banks’ provision of their own default probabilities for equity participation • Banks’ estimation of the market value decrease of the equity participation.


Either way, Islamic banks would be able to take advantage of special treatment. In-


Basel II: Available Approaches for Operational Risk


Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. this includes legal risk, but excludes strategic and reputational risk. Similar to the calculation of the minimum capital requirements for credit risk, three methodologies are available for the calculation of operational risk capital


charges.


Basic Indicator Approach The capital change is calculated as a fixed percentage (15%) of average gross income over the previouse three years. The percentage is determined by the local


regulator.


Standardized Approach The banks’ activities are divided into eight busi- ness lines, and the capital change is calculated per business line as a percentage of gross income. The percentages differ according to the business line and


are set by the local regulator.


Advanced Measurement Approach (AMA) Banks apply their own internally developed model, which incorporates quantitative and qualitative criteria such as internal loss data, key risk indicatores, sce- nario analysis and self-assessment.


Pillar 1


Minimum Capital Requirements (Addressing risk)


This pillar is concerned with the maintenance of regulatory capital calculated for three major components of risk a bank faces:


• credit risk


• operational risk • market risk


As the global banking system continues to phase in the Basel II recommendations, the minimum capital requirements will transform from their current standardised state to a more refined and specific form, with each re- quirement being the result of each individual bank’s development programme specifically for each particular risk category. By develop- ing their own bespoke risk measurement infrastructures thus, the banks will have the advantage of being rewarded with poten- tially lower risk capital requirements. Such a progression will help build a more integrated relationship between the concepts of regula- tory capital and economic profit.


Pillar 2


Supervisory Review The second pillar relates to the regulatory response to the first, giving regulators updated tools built upon the ones made available to them by Basel I. The pillar also provides a framework for dealing with all other risks a bank may be vulner- able to:


• systematic risk • pension risk


• concentration risk • strategic risk • reputation risk • liquidity risk • legal risk


The accord combines these risks under the term of re- sidual risk and gives banks the authority to review their risk management systems.


50 Global Islamic Finance February 2011 Pillar 3


Market Discipline (the promotion of greater stability in the financial system)


This pillar is in relation to the regulations Basel II recom- mends to prevent banks taking excessive risk. Individual governments already apply such regulations to their respective jurisdictions, but the aim of this pillar is to provide an overall international regulatory frame- work to encourage standardised and effective market discipline


worldwide.


deed, the IRB approach to equity participa- tion may well encourage Islamic banking institutions to increasingly utilise mudaraba and musharaka transactions. However, in order to obtain supervisory approval to apply the IRB approach, Islamic banks will have to deal with a number of obstacles regarding size and risk management. In fact, in order to implement Basel II in general, there are a variety of obstacles Islamic banking must overcome.


Obstacles for Islamic Banks in Implement- ing Basel II Islamic banks are gradually handling risk in a much better way as they move towards im- plementing Basel II. Islamic banks, however, before getting closer to adopting the more advanced features of Basel II, must ensure that a few major obstacles are efficiently dealt with and turned towards their advan- tage. Using advanced approaches for the calculation and management of risk is cur- rently difficult in some of the Islamic banks operating in the Middle East and Asian coun- tries due to the aforementioned shortage of historical data.


Such historical default data, for instance, is required to calculate the probability of default and the potential loss given the esti- mates of default. This type of data, however, is not easily available in most of Islamic countries. National Commercial Bank, Al-Ra- jhi Bank and several other banks are work- ing towards creating a national data pooling system for handling credit risk. Bahrain, Ma- laysia, Qatar and the UAE have developed national databases and banks in the Middle Eastern countries are working on collecting their own historical data.


Despite all this, much more needs to be done in order to develop globally competi- tive databases for the Islamic banking sec- tor. Furthermore, in order to combine data at an international level, the central banks of the Islamic countries must give their banks the freedom to disclose information. This would require the cooperation of the central banks across all Islamic countries. Collec- tives of Islamic countries would do well to adopt a standardised policy of disclosing data on their exposures. The concept of us- ing a proxy database to begin with is current- ly being worked upon to ensure that Islamic banks at least start using more advanced Basel II reporting and compliance. Islamic banking presents unique risks to the finan- cial system. This is due to the profit and loss sharing method of financing so character- istic of sharia’a-compliant banking, as well as particular contractual features of Islamic financial products. The profit and loss shar- ing shifts the risks in the institution to invest- ment depositors to a certain extent. It also makes Islamic banks vulnerable to a range


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