Risk Management gif


of risks, including those risks that are nor- mally carried by equity investors, because of the following features:


• The profit and loss sharing mechanism is very complex and therefore requires greater auditing of projects to guaran- tee proper governance and suitable valuation. • It is not permissible for Profit and loss sharing to be made dependent on col- lateral or guarantees to decrease credit risk. • Product standardisation becomes more complex because of the multiplicity of potential financing methods that can be based upon each product, increased operational risk, and legal uncertainty in interpreting contracts. • Because of the absence of Shariah- compliant instruments such as treasury bills, it is a challenge to manage asset and liability mismatches and hence, li- quidity risks are substantial, to say the least.


Commodity inventories on Islamic banking institution balance sheets increase the size price and operational risks. Furthermore, due to Islamic banking contracts that con- sist of deferred delivery of products, such as salam and istisna, considerable additional price risks arise. In order to address the unique risks of Islamic banking, adequate capital and reserves are required, which is where Basel II presents itself as a useful set of recommendations and guidelines for Islamic banking. Also required is control of risks in an appropriate disclosure regime. Given information asymmetries and incon- sistencies are widely present in Islamic banking, there is a strong need for better rules and practices for accounting, govern- ance, disclosure and auditing.


Furthermore, there is a need for the devel- opment of an infrastructure that facilitates effective liquidity management. Islamic fi- nancial institutions have their work cut for them in regards to the analysis of the risk characteristics of Islamic financial products and understanding how to treat these prod- ucts under Basel II. In 2010 ABC Islamic Bank in the UAE released a disclosure of Basel II which outlined how the system was implemented into their bank and the sta- tistical data which showed how the Basel II had a positive impact on Islamic banking. This disclosure helped the bank to further identify the characteristics of Islamic finan- cial commodities under the Basel II and fur- ther helped to progress the sector. Islamic banking bodies are working towards clari- fying these issues, the knowledge that the rewards Basel II could potentially bring the Islamic banking industry would be worth it.


Benefits of Basel II for Islamic Banks The eventual successful implementation of Basel II for Islamic banks would potentially yield rewards such as increased credibility and sustainable worldwide growth. Malay- sia, commonly hailed as an Islamic finance centre with its finger on the pulse, has in- dicated it is aware of the potential for such benefits by developing the Capital Adequacy Framework for Islamic Banks (CAFIB), its own sharia’a-friendly answer to Basel II. The framework was developed upon the basis of the Capital Adequacy Standard issued back in 2006 by the IFSB. Several Malaysia-based Islamic banks have already adopted it.


According to a 2008 article by Islamic Fi- nance Asia, the country’s central bank, Bank Negara Malaysia is of the opinion, “that most Islamic banks had been ob- served to experience modest improvements in the capital adequacy ratio following the implementation of CAFIB, with increases in capital requirements due to the introduction of a new capital charge for operational risk being mitigated through capital savings en- joyed from lower risk weights for residential mortgages and retail exposures under the new framework.” Furthermore, “the central bank expects to see capital savings and im- proved risk management practices in the in- dustry through the supervisory expectations embedded within the framework, such as for the recognition of credit risk mitigants for purposes of capital savings. This would also be supported by an enhanced risk manage- ment system infrastructure.”


The implementation of a new capital ad- equacy framework by Islamic banks will enhance their credibility and sustain their growth globally. Most Islamic banks world- wide implemented the new framework. Bank Negara Malaysia (BNM) said that most Islamic banks had been observed to expe- rience modest improvements in the capital adequacy ratio following the implementa- tion of CAFIB, with increases in capital re- quirements due to the introduction of a new capital charge for operational risk being miti- gated through capital savings enjoyed from lower risk weights for residential mortgages and retail exposures under the new frame- work


Certain other countries obviously agree with BNM that the Basel II philosophy can be beneficial to Islamic banking as they are now planning to follow the South-East Asian country’s lead and implement the accord in their own Islamic banks. For instance, last July, Bangladesh’s The Financial Express (FE) reported that the country’s central bank, the Bangladesh Bank (BB) had released an instruction on risk factors associated with Islamic financing with the aim of bringing the nation’s Islamic banking industry in line


with Basel II. A senior official at BB had told FE that, “We’ve issued the instruction under the guideline on risk based capital adequacy for banks to identify credit risks of the Is- lamic banks.” He reportedly added that both standalone Islamic banks and conventional banks with Islamic banking windows would be expected to compute their risk weighted assets and capital reserves requirements for implementation of Basel II. This would involve the banking institutions measuring and applying capital charges against credit, market and operational risk. There are cur- rently seven Islamic standalones and 13 Is- lamic banking windows in Bangladesh.


The official disclosed, “The banks will have to submit their statements on a quarterly ba- sis in prescribed forms to the department of off-site supervision of the central bank from 30th June this year [2009].” Basel II had ac- tually come into effect in Bangladesh on 1st January 2009, but it was only in July that BB made this concerted effort to apply it to Is- lamic banks. The banks have been required to actually implement the accord since Janu- ary of this year.


Considering, as we have already explained, such measurements are a challenge for Is- lamic banks to undertake, it certainly proves the regulator’s determination to bring its country’s banking system in line with Basel II. This, in turn, is surely a testament to the positive power, regulators believe Basel II has. This is not just the case in Malaysia and Bangladesh, but all across the Islamic world. It may take a lot of hard work and amend- ments to reach the point where all Islamic countries have implemented sharia’a-friend- ly equivalents of Basel II, but it would appear that many of them are of the opinion it will all be worth it in the end.


In the next issue Global Islamic Finance Magazine will discuss features of Basel III.


References and Further Reading:


• Eva Catarineu-Rabell, Patricia Jackson and Dimitrios P. Tsomocos, Procyclicality and the new Basel Accord - banks’ choice of loan rating system, October 2005, Eco- nomic Theory, Volume 26, Number 3 • Abdul Hassan, Jumping Hurdles: Adopting Basel II Standards in Islamic Banks, April 2005, The Islamic Foundation • Don Brownlow, Islamic banking and Basel II: Challenges Ahead, April 2008, New Ho- rizon • Siddique Islam, Islamic banks to weigh risk factors according to Basel-II, July 2009, The Financial Express • Islamic Finance Asia contributor, Basel II Enhances Islamic Banks, August/Septem- ber 2008, Islamic Finance Asia


2011 February Global Islamic Finance 51 gif


Page 1  |  Page 2  |  Page 3  |  Page 4  |  Page 5  |  Page 6  |  Page 7  |  Page 8  |  Page 9  |  Page 10  |  Page 11  |  Page 12  |  Page 13  |  Page 14  |  Page 15  |  Page 16  |  Page 17  |  Page 18  |  Page 19  |  Page 20  |  Page 21  |  Page 22  |  Page 23  |  Page 24  |  Page 25  |  Page 26  |  Page 27  |  Page 28  |  Page 29  |  Page 30  |  Page 31  |  Page 32  |  Page 33  |  Page 34  |  Page 35  |  Page 36  |  Page 37  |  Page 38  |  Page 39  |  Page 40  |  Page 41  |  Page 42  |  Page 43  |  Page 44  |  Page 45  |  Page 46  |  Page 47  |  Page 48  |  Page 49  |  Page 50  |  Page 51  |  Page 52  |  Page 53  |  Page 54  |  Page 55  |  Page 56  |  Page 57  |  Page 58  |  Page 59  |  Page 60  |  Page 61  |  Page 62  |  Page 63  |  Page 64  |  Page 65  |  Page 66  |  Page 67  |  Page 68  |  Page 69  |  Page 70  |  Page 71  |  Page 72  |  Page 73  |  Page 74  |  Page 75  |  Page 76  |  Page 77  |  Page 78  |  Page 79  |  Page 80  |  Page 81  |  Page 82  |  Page 83  |  Page 84  |  Page 85  |  Page 86  |  Page 87  |  Page 88