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Managing Uncertainty in an Islamicfinancial institution
Presentation to the PRMIA Singapore Chapter
May 2010
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This document is exclusively intended for use by selected clients. Distribution, quotations and duplications even in the form of extracts for thirdparties is only permitted upon prior written consent of Ma Lee Advisory, Limited.
Copyright 2010 Ma Lee Advisory, Limited.
The text and graphs compiled in this presentation do not represent complete documentation.
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Managing and understanding risk overcomes uncertainty
The management of risk is a process by which exposures in a financial institution are
identified
measured and assessed
mitigated and controlled
reported and monitored
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Agenda
Brief Overview of Islamic finance
Common risks faced by Islamic financial institutions and their financial instruments.
Specific risks of Shari'ah compliant banking products
Reducing risk in Islamic financial institutions
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Background
Islamic financial institutions (IFI) are operating in over 75 countries, managing between $500billion and $1 trillion assets
Islam prohibits dealing in interest as well as any investment in liquor, swine/pork products,gambling, pornography and anything else, which the SharIah deem unlawful
Islamic financial system employs the concept of participation in the enterprise, utilizing thefunds at risk on a profit-and- loss-sharing basis
Islamic banking, with 15 to 20% growth a year, has emerged as one of the vital pillars of theglobal economic system
Increasing linkages between OIC financial centers such as Kuala Lumpur, Dubai and Bahrain
Significant interest in Islamic finance being shown by countries such as UK, France,Australia, Singapore, Hong Kong, China and Japan
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Focus : Islamic Finance News (Reuters)
Significant insight into real-time Islamic events
Source: ThompsonReuters
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What is an Islamic financial institution
Financing InvestmentMoneyMarket
Islamic Financial Institution
Shareholder Depositor
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Features of Islamic banking
Interest (riba)-free - money is only a medium for exchange; one can not earn more money byitself without putting it real productive, action
Uncertainty or lack of knowledge (gharar)-free must avoid all disputes due to unfairness indealings due to lack of knowledge
Gambling (maysir)-free - transfers of wealth, not the creation of new wealth
Not involved in something impure or not halal -religious and ethical value considerations
Not in direct conflict with established Shariah principles in muamalah
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Focus : Islamic Glossary (Reuters)
A glossary for clarifying even the most esoteric products
Source: ThompsonReuters
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Recent market events
Repatriation of dollars by Arab investors
Liquidity due to oil revenues
Sukuk defaults
Dubai under crisis
Regulatory Activity
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Focus : Crisis & Islamic Finance [ISLF] (Reuters)
Up to date news on the latest industry developments
Source: ThompsonReuters
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Sovereign and agency debt issuance
Dubai: $1 billion
Qatar: $700 million
Pakistan: $600 million
Malaysia: $600 million
German State of Saxony-Anhalt:100 million
Bahrain: $79.5 million
Islamic Development Bank: $400 million
World Bank: $200 million
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Focus : Malaysian Sukuk (Reuters)
Everything you need to know about Sukuks
Source: ThompsonReuters
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Corporate debt issuance
DP World: 3.5 billion 7.5% Sukuk, convertible into equity at the time of a qualifying initialpublic offering
National Central Cooling Company: $200 million, rated BBB- by S&P
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Focus : DP World Sukuk Limited (Reuters)
Deep dive into specific issuances
Source: ThompsonReuters
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Focus : Terms and Conditions (Reuters)
and deeper
Source: ThompsonReuters
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Recent Singapore Developments
Singapore is encouraging the growth of Islamic finance and recently announced its intentionto become a hub of Islamic finance
Beginning in 2005, banks in Singapore were allowed to offer Murabaha financing
The Development Bank of Singapore (DBS) recently established the Islamic Bank of Asia, tofocus on wealth management and capital market instruments for corporate and privatebanking clients in the Middle East and Asia
There is a governmental initiative to achieve tax equality between approved Islamic productsand conventional financing arrangements
Singapore is moving quickly to remove the double stamp duty hit on Murabaha and Ijaracontracts
Tax incentives granted to qualifying debt securities extended to approved Islamic bonds
No stamp duty on the transfer of asset to SPV set up for Islamic Financing purposes
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Focus : Islamic Scene in Singapore (Reuters)
And of course a great source of local information
Source: ThompsonReuters
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Conventional international banks with Islamic activities
Citigroup
HSBC
Deutsche Bank
UBS
ABN AMRO
Standard Chartered Bank
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Focus : HSBC Islamic (Reuters)
Deep dive into a financial institutions activities
Source: ThompsonReuters
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Agenda
Brief Overview of Islamic finance
Common risks faced by Islamic financial institutions and their financial instruments.
Specific risks of Shari'ah compliant banking products
Reducing risk in Islamic financial institutions
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Does Islamic banking risk differ from Conventional bankingrisk?
Islamic Banking is ALL about who bears risk
Trade credit ?
Asset backed secured or unsecured ?
Debt or equity ? Leasing ?
Repos / Murabahah ?
Fund management ?
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Risk profile of Islamic financial institutions
0%
20%
40%
60%
80%
100%
mur
abah
ah
mudha
raba
h
musha
raka
hija
ra
istis
na'
sala
m
D.musha
raka
h
Credit Risk Market Risk Liquidity Risk Operational Risk
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unique risks in an Islamic financial institution
Rate of return risk
Shariah risk
Equity investment or position risk
Risk transformation
Unrealistic funding costs
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Focus : Risk Islamic (Reuters)
Ability to search on key words, like risk management activities
Source: ThompsonReuters
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Rate of return risk
Associated with the management of assets and liabilities
Fixed rate long term assets funded by variable rate short-term liabilities
Movement in benchmark rates may result in fund providers having expectations of a higher
rate of return
Subsequently, it may result in displaced commercial risk where due to market pressure,Islamic bank needs to pay a return that exceeds the rate that has been earned on its assets.
If Islamic bank does not yield to market pressure, they may lose their fund providers whichcould consequently lead to liquidity risk
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Shariah risk
Limited available talent pool, especially for positions on the Shariah board
It takes many years of education and practical experience to become a Shariah scholar
Different Shariah boards even within the same country may deliver different interpretations
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Agenda
Brief Overview of Islamic finance
Common risks faced by Islamic financial institutions and their financial instruments.
Specific risks of Shari'ah compliant banking products
Reducing risk in Islamic financial institutions
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Unique Credit Risks
Refusing to honor the promise to buy a Murabaha contract
Refusing to honor the specific aspects of a Salam contract
Declining to honor the promise to accept the delivery agreement of a Istisna contracts
Non-compliance with the leasing structure of Ijara contracts
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Focus : More Islamic Risk Insights (Reuters)
Marketplace trends on Islamic finance
Source: ThompsonReuters
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Other risks may arise from various sources
Limited secondary trading market for Sukuk
Directly expose to commodity price risk because Islamic banks carry inventory items
Non-standardized nature of some Islamic products
The lack of an efficient and reliable Shariah legislation system to enforce financial contracts
Lack of risk-hedging instruments due to the prohibition against ribaand some fiqhissues inthe interpretation of ghararmean that many risk hedging instruments based on traditionaltools, such as option, futures and forwards are not available to Islamic banks
Underdeveloped money market and government securities based on profit loss sharing
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Islamic banks have ineffective liquidity management
Islamic banks tend to have a concentrated base of deposits and assets.
Islamic banks have been forced to hold a large proportion of their assets in reserve accountsin central banks or in correspondent accounts than conventional banks
Islamic banks face underdeveloped or nonexistent money markets
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Studies have also identified weaknesses and vulnerabilitiesin the areas of risk management and governance
The failure of systems, processes, and procedures, is one area of concern
The existence of weak internal control processes
The quality of management, technical expertise, and professionalism, is also an issue
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Then there is
A lack of good risk management professionals in the Islamic financial institution
Risk management Is not seen as a core competency
Education of the Boards is lacking on capital adequacy and risk mitigation
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Agenda
Brief Overview of Islamic finance
Common risks faced by Islamic financial institutions and their financial instruments.
Specific risks of Shari'ah compliant banking products
Reducing risk in Islamic financial institutions
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Essentially an integrated approach to risk management,governance and compliance
Enterprise Risk ManagementIdentifying Risks That May Affect Our
Ability to Achieve ObjectivesAnd Determining How to Respond
ComplianceExecuting as Expected To Support Achievement of All Objectives
GovernanceDeterminingObjectives
and KnowingWe Are Executing
Appropriately
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Management, the Board, and the regulators each have arole to play in ensuring that risk is managed effectively
Management level
The quality of strategic and operational monitoring and management
Board level
The quality of questions being asked about the performance of the financial institution underthe worst-possible-stress scenarios
Regulatory level The quality of published regulatory requirements, so far these have lack any quantitative
criteria or guidelines
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Both the Board and management should ask questions
Do you feel your organization is taking the appropriate level of risk?
Do you know what the risks are for the organization you are supporting?
Does management agree on the importance of these risks?
Does management know the real level of impact and likelihood for these risks?
For risks that are undermanaged, does your organization have a plan in place to improve themanagement of these risks?
For risks that are over managed, does your organization have a plan in place to improve the
management of these risks?
Does your organization take inconsistent levels of risks?
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The Board must take responsibility for defining capacity,appetite and limits
Capacity
Capacity represents the maximum amount of risk that can be supported
Risk Capacity is determined by considering the following:
Availability of capital resources
Ability to raise capital (access to capital markets)
Earnings strength and stability - growth in capital over the planning horizon
Appetite Risk Appetite serves as an overall guide to resource and capital allocation
Business strategy must be aligned with risk appetite
Limits
Risk Appetite should be allocated to individual risk types, businesses based upon capital
requirements relative to potential returns and risk concentrations
Limits should effectively control risks within the context of the overall risk appetite
Limits should reflect enterprise Risk Preferences and align to support strategic plans andcapital allocation
Limits should be set at a level which may be periodically tested (i.e., limits should beestablished at levels that may be exceeded at times)
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Management must measure risk and provide frameworks toeffectively control risk taking
A robust liquidity risk management framework and governance process
Gap analysis for a timeframe in which meaningful actions can be taken or one far enoughforward that underlying information can be relied upon with a significant degree of certainty
Detailed understanding (nature and purpose) of assets held and liabilities, contingentobligations, the reliability of credit availability, and the potential market reaction to actionsconsidered to be taken the in response to market behaviors
Implement information systems
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The Islamic financial institution should align businessstrategy to risk tolerance
How much on balance sheet exposure is allowed
What is the proportion of total reliable liquidity
What is the maximum refinancing requirement during a period (day, week, etc)
What concentration is allowed by
Any one provider
Any one product
What is the target surplus based on expected or worst case probabilities?
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Challenges in Islamic finance
Organization and resource issues
Liquidity management constraints
Currency risk and volatility
Repatriation issues
Regulation constantly changing
Information and data restraints
Internal control issues
Shariah compliance is crucial
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Question & Answer
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About Ma Lee Advisory, Limited
Ma Lee is a boutique Asian advisory firm, focused on client service through a soundstrategy of producing and implementing results. The firm delivers solutions in threeprofessional areas, Strategy, Risk Management, and Corporate Finance, with thesupport of seasoned subject matter experts with over 20 years of exceptional, practical
experience in industry, Big-4 accounting firms, and consultancies. Since inception, threeyears ago, Ma Lee has been advising some of the largest financial institutions acrossAsia, from our home office in Hong Kong. Project delivery occurs on the Chinesemainland, Korea, Malaysia, Singapore, as well as within the GCC.