Chapter 7
Operational Risk Exposures of Islamic Banks
1. INTRODUCTION
Following the downturn of the financial markets in 2008, the Basel Committee on Banking Supervision (BCBS) has been striving to refine the rules for global financial services. A significant number of financial institutions, especially those classified as SIFI (systematically important financial institutions) had crossed the boundaries of risk taking. In the case of a few of them, their eventual failure posed systemic risks to the world economy, necessitating intervention by governments. As a result, international standard-setting organisations have been working to put in place a new set of regulations to govern financial markets more effectively. One of the most notable efforts made by the BCBS is the introduction of a set of guidelines known collectively as Basel III. At the same time, the Islamic Financial Services Board (IFSB) has formed several working groups with the aim of complementing this work of the BCBS, with regard, for instance, to liquidity risk management, stress testing, and revised requirements for capital adequacy and the supervisory review process.
While Basel III focuses on regulating solvency and liquidity to ensure sufficient capital to return funds to depositors and to be able to survive a protracted liquidity stress situation, the regulations come with some expected changes with respect to the way the institutions operate, a number of which this chapter strives to highlight. In addition, the chapter seeks to explain how the IFSB will adapt such requirements for the application by Islamic banking institutions, with particular reference to operational and related risks.
Like Basel II, Basel III did not make any distinction between how operational risk is defined and measured. The changes expected as a result of the Basel III requirements and the IFSB future standards will require Islamic banks to re-examine their processes and procedures.
In Basel II, operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events . . . [including] legal risk . . . but [excluding] strategic and reputational risk.” Legal risk, in turn, is defined as including, without being limited to, “exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.”
Cases of operational failures in the financial services industry brought operational risk to attention as an important area for regulation. The operational failures manifested themselves in different activities of these institutions, including failure in risk oversight by senior management, and poor accounting and auditing processes.
Basel II introduced a capital charge for operational risk, using a methodology described below. However, the use of a capital charge for this purpose is somewhat controversial. A major reason for this is that the nature of operational risk is such that measuring it for capital adequacy purposes is problematic.
2. BASEL III REQUIREMENTS AND THEIR IMPLICATIONS FOR OPERATIONAL RISK MANAGEMENT
The proposed new regulations on the banking sector, known as Basel III, will improve global financial stability. However, a by-product of the regulation will be the adoption of tighter credit conditions for certain business activities. Banks will have to comply gradually with the new, stricter rules, as the full implementation of Basel III is not expected before 2019. Nevertheless, banks need to be aware of the risks implicit in the context of operations.
2.1 New Capital Buffer
Basel III requires a minimum level of common equity (Common Equity Tier 1 or CET1) set at 4.5 percent, a the total Tier 1 capital requirement of 6 percent, and a total capital requirement (Tiers 1 and 2) of 8 percent, with an additional 2.5 percent capital conservation buffer (CCB) consisting of common equity in addition to CET1. Thus, the total common equity requirement is 6 percent and the total capital requirement is 10.5 percent (compared to 8 percent in Basel II). The CCB requirement is intended to oblige banks to build up the buffer in favourable economic conditions so as to be able to absorb shocks in periods of stress and, at the same time, gives the regulatory authorities the ability to impose restrictions on paying dividends and bonuses when the buffer falls below the required level. Finally, on the basis of macroprudential considerations of counter-cyclicality, Basel III proposes a further counter-cyclical buffer, which supervisory authorities can require to be built up during periods of economic expansion so that excess credit growth is restrained, while on the other hand the buffer is intended to enable banks to have sufficient capital to continue extending credit during periods of economic contraction.
2.2 New Leverage Ratio, Liquidity Cover Ratio, and Net Stable Funding Ratio
The new leverage ratio (defined as a minimum ratio of Tier 1 capital to total exposures) is intended to restrain excessive leverage by putting a cap on the build-up of leverage, as well as to introduce a safeguard against model risk and measurement errors. In addition, by virtue of the liquidity cover ratio (LCR), the institution is expected to maintain a sufficient level of high quality and unencumbered liquid assets (HQLA) to cover total cash outflows over a 30-day period in stressed conditions. In doing so, the institution is expected to draw up specific operational procedure in ensuring such level or assets meet the expected regulatory requirements. Finally, the net stable funding ratio is intended to require banks to have sufficient stable sources of funding to allow for a sustainable maturity structure of assets and liabilities over a one-year time horizon under extended stressed credit conditions.
2.3 SIFIs
The introduction of the concept of SIFIs has required regulatory authorities to develop policies to reduce the riskiness of systemically important institutions from an international (cross-border) perspective, with the option for supervisors to pay attention to institutions that are significant at the regional or national level. The introduction of this requirement is intended to reduce the risk of failure of certain institutions by requiring the regulatory authority to step in with increased supervision. In this respect, the need to manage risk before it reaches systemic proportions is highly desirable because the requirement not only requires the supervisors to step in by putting in place necessary management and extra processes, but also provides the basis for requiring shareholders to provide extra capital buffers to absorb losses.
2.4 Stress Testing
Basel III sets out 15 principles for stress testing to be followed by financial institutions and a further 6 to be followed by supervisors. The principles cover the overall objectives, governance, design, and implementation of stress testing programmes as well as issues related to stress testing of individual risks and products The aim is to induce financial institutions to implement a robust stress testing programme, and to review and validate the methodologies and hypotheses as well as the chosen scenarios.
3. OPERATIONAL RISK: THE BASEL METHODOLOGY
As for the methodology for operational risk, the requirement remains unchanged. To reiterate, the Basel II framework presents three methods for calculating operational risk charges “in a continuum of increasing sophistication and risk sensitivity.” These are: (1) the Basic Indicator Approach; (2) the Standardised Approach; and (3) the Advanced Measurement Approaches. Internationally active banks and those with significant risk exposures are expected by the BCBS to use a more sophisticated approach than the Basic Indicator Approach, one appropriate for the “risk profile of the institution.”
3.1 The Basic Indicator Approach (BIA)
This approach uses a gross income as a proxy measure of exposure to operational risk. Hence, it requires banks to hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive gross income. Years in which gross income is negative are ignored. The proposed percentage is 15 percent. Gross income is defined (for conventional banks) as “net interest income plus net non-interest income.” This measure should: (1) be gross of (a) any provisions and (b) operating expenses, including fees paid to outsourcing service providers (however, fees received for providing outsourcing services should be included); and (2) exclude (a) realised profits/losses from the sale of securities in the banking book, and (b) extraordinary or irregular items, as well as income derived from insurance.
It will be clear from the above that if any such approach—either the basic indicator or the standardised approach (which uses similar but more refined proxy measures of operational risk exposure)—is to be applied to Islamic banks, gross income needs to be defined so as to reflect the nature of their operations, as discussed in Section 3.2 below.
3.2 The Standardised Approach (SA)
This is a refinement of the BIA in which banks’ activities (and gross income) are divided into eight lines of business (LOBs), and the total capital charge is calculated as the three-year average of the simple addition of the capital charges across the eight business lines in each year. A negative capital charge in any one year for one LOB is offset against the positive capital charges for the other LOBs in that year, unless the total for the year is negative, in which case the input for the year to the three-year calculation is zero. The percentage for the different LOBs lines varies from 18 percent for corporate finance, trading and sales, and payment and settlement, through 15 percent for commercial banking and agency services, to 12 percent for retail banking, asset management, and retail brokerage.
Basel II also allows a variant of the SA, the alternative standardised approach (ASA), to be used subject to national supervisory discretion. Under the ASA, the capital charges for two LOBs, commercial and retail banking, are calculated using “loans and advances” instead of gross income as the indicators of exposure to which the percentages (15 and 12 percent, respectively) are applied. Commercial and retail banking may be aggregated into one LOB, in which case the percentage to be applied is 15 percent.
3.3 Advanced Measurement Approaches (AMA)
These approaches, use of which is subject to supervisory approval, allow banks to develop their own proxy measures of operational risk exposure.
4. OPERATIONAL RISK IN ISLAMIC BANKS
In the context of the Islamic financial services industry, appropriate systems, processes, and products are all recent developments. The Islamic Financial Services Board (IFSB) had adopted the same definition with some changes to cater for the specific nature of Islamic banking operations. Operational risk as per the IFSB is defined as “the risk of loss resulting from inadequate or failed internal processes, people, and systems or from external events, which includes but is not limited to, legal risk and Shari’ah–non-compliance risk. This definition excludes strategic and reputational risk.” Continued growth in the industry poses a continual challenge in these areas of development, and failures in managing these areas will bring negative consequences.
4.1 Operational Risk Exposures in Islamic Banks
The crisis and recent regulatory development imposed on conventional institutions will have an implication on the management of the operational risk in Islamic banks. Among other things, in the medium term, as banks increase their capital ratios, the limited Shari’ah-compliant instruments may have an impact on the way Islamic banks meet the prudential requirements. The proposed new regulation is also likely to result in significantly higher IT costs due to changes in some processes that need to be improved, as well as in the management of liquidity and stress testing infrastructural requirements.
Operational risks faced by Islamic banks can be divided into three categories (certain risks that could be classified as legal risks are included, as mentioned in (c) (ii) below:
Though the nature of operational risk related to the banking operations of Islamic banks can be similar to that of conventional banks, the severity of such risk may be greater in an Islamic bank in certain cases, as, for example: (i) Shari’ah-compliant products may involve more processing steps than their conventional counterparts; (ii) Islamic banks typically hold more physical assets on their balance sheets than conventional banks; and (iii) an Islamic bank may encounter higher risk related to information technology products and systems due to scarcity of standardised products for Islamic banks.
With regard to (a) above, it should be noted that Islamic products tend to be more complex than their conventional counterparts, requiring more processing steps and hence leaving more room for error. Islamic banks typically hold more physical assets on their balance sheets than conventional banks and are exposed to operational risks associated with these. In addition, the operational risks associated with information technology (IT) in Islamic banks may exceed those in conventional banks for which more standardised software is likely to be available.
With regard to (b)(i) above, Shari’ah compliance is critical to an Islamic bank’s operations, and such compliance requirements must permeate throughout the organisation and its products and activities. As a majority of the fund providers use Shari’ah-compliant banking services as a matter of principle, their perception regarding the Islamic bank’s compliance with Shari’ah rules and principles is of great importance in maintaining their customer loyalty. In this regard, Shari’ah compliance is considered as falling within a higher-priority category in relation to other identified risks. However, it should be noted that reputational risk, including that relating to Shari’ah compliance, falls outside the Basel II definition of operational risk.
In most jurisdictions, Shari’ah compliance is achieved principally through the mechanism of a separate Shari’ah supervisory board, which has the responsibility of laying down the Shari’ah principles and rules to which the institution should adhere. The Shari’ah supervisory boards, typically, also advise on any issues surrounding new products or new structures and have a responsibility to report, at year-end, on satisfactory Shari’ah compliance by their associated institutions in the process, documentation, structure, as well as whenever the Islamic bank accepts deposits and investment funds. Such boards satisfy themselves as to proper adherence to the principles and rules laid down through a process of internal and external Shari’ah reviews. The management of Shari’ah compliance risk therefore requires that there should be timely information concerning products, services, and findings from the management to the Shari’ah supervisory board. Since the industry is growing at a rapid pace, the requirement for expertise in Shari’ah aspects in various departments is a significant factor. Inadequately trained staff will expose the Islamic bank unnecessarily to such operational risks, including the risk of income not being recognised as permissible when there is a failure in Shari’ah compliance.
As for (b)(ii) above, fiduciary risk is the risk that arises from an Islamic bank’s potential failure to perform in accordance with explicit and implicit standards applicable to its fiduciary responsibilities, especially in its role as mudarib. As a result of losses on investments, an Islamic bank may become insolvent and therefore unable either (a) to meet the demands of current account holders for repayment of their funds, or (b) to safeguard the interests of its investment account holders (IAHs). An Islamic bank may fail to perform due diligence or to act with sufficient prudence when making and managing investments, resulting in risks of forgone profits or of losses to its IAHs.
4.2 Capital Requirements for Operational Risk in Islamic Banks
The IFSB has set out capital requirements for Islamic banks in its Capital Adequacy Standard IFSB-2 (December 2005).1 These are based on the basic indicator approach, with gross income being redefined in an appropriate manner as indicated below, and 15 percent being used as the standard percentage. As the LOBs into which Islamic banks are organised are different from those set out in Basel II, the IFSB proposes that, at the present stage, the basic indicator approach be used by Islamic banks. However, subject to the supervisory authority defining the applicable LOBs, it may allow Islamic banks in its jurisdiction to apply the Standardised Approach (SA) in which the percentage (12, 15, or 18 percent) of gross income is to be set aside according to the LOB.
Gross income is defined as the sum of:
Less:
Net income from financing activities under (a) includes both the share of IAHs and the Islamic bank’s share as mudarib or as managing partner in a musharakah with IAHs. The IAHs’ share of such income is deducted under (d).
Gross income excludes extraordinary income and income from insurance activities.
4.3 Risk Management Guidelines
In addition, guidelines for the management of operational risk are proposed by the IFSB. These guidelines operate through process regulation, which requires the Islamic bank to have in place appropriate processes and procedures to identify, measure, monitor, and control operational risk.
5. UNIQUE OPERATIONAL RISKS OF ISLAMIC FINANCING/INVESTMENT MODES
In this section, without seeking to be exhaustive, we review some aspects that may give rise to operational risks consequential upon specific financing or investment modes.
5.1 Murabahah
Murabahah is one of the most predominantly used contracts in Islamic finance. Apart from credit risk exposures, there are two types of operational risk relating to the structure of a murabahah contract:
In addition, problems may arise if the murabahah customer acts as the Islamic bank’s agent in the purchase of the asset that is the subject matter of the contract. For the murabahah to be valid, title to the asset must first pass to the Islamic bank and not directly to the customer. The documentation, including letters of credit, must be drawn up so as to ensure this.
Islamic banks can be involved in commodity murabahah transaction (CMT)–based financing in the following forms:
Some aspects of commodities’ liquidity and delivery, their settlement and exit strategies, legal risk, and Shari’ah–non-compliance risk may entail operational risks consequential to the CMT structure.
5.2 Salam and Parallel Salam
Salam is a type of forward contract where an Islamic bank assumes the role of the forward purchaser of a commodity. In assuming the role of the purchaser, the bank exposes itself to the following operational risks:
5.3 Istisna’a and Parallel Istisna’a
Istisna’a is another type of forward contract, but the role of an Islamic bank as a financial intermediary differs from that in a salam contract. An istisna’a contract is an agreement between a seller (al-sani’) and the (ultimate) buyer (al-mustasni’) to manufacture or construct a nonexistent asset which is to be manufactured or constructed according to the ultimate buyer’s specifications and is to be delivered on a specified future date at a predetermined selling price.
In an istisna’a contract, price and other necessary specifications must also be fixed and fully settled between the buyer and manufacturer/builder. The payments by the buyer in istisna’a may be made in advance during the period of construction reflecting stages of completion, or deferred to a specified future date. The contract of istisna’a is a binding contract that cannot be cancelled unilaterally by either party once the manufacturing or construction starts. If the subject matter does not conform to the specification agreed upon, the buyer has the option to accept or to refuse the subject matter. The subject matter on which transaction of istisna’a is based is always an item that needs to be manufactured or constructed, such as a ship, an aircraft, or a building, and it cannot be an existing and designated asset. Istisna’a may also be used for similar projects like installation of an air-conditioning plant in the customer’s factory, or building a bridge or a highway.
In respect to the above, the common practice is that the bank contracts to supply a constructed asset (such as a building or a ship) for a customer. In turn, the bank enters into another istisna’a with a contractor in order to have the asset constructed.2 Its reliance on the counterparty in the other istisna’a (the subcontractor) exposes it to various operational risks, which need to be managed by a combination of legal precautions, due diligence in choosing subcontractors, and technical management by appropriately qualified staff or consultants of the execution of the contract by the subcontractor. Islamic banks that specialise in istisna’a financing may have an engineering department. Risks may include the following:
5.4 Ijarah and Ijarah Muntahia Bittamleek
In simple terms, an ijarah contract is an operating lease, whereas ijarah muntahia bittamleek (IMB) is a lease-to-purchase (a Shari’ah-compliant alternative to a finance lease). While operational risk exposures during the purchase and holding of the assets may be similar to those in the case of murabahah, other operational risk aspects include the following:
5.5 Musharakah
Musharakah is a profit- and loss-sharing partnership contract. The Islamic bank may enter into a musharakah with a customer for the purpose of providing a Shari’ah-compliant financing facility to the customer on a profit- and loss-sharing basis. The customer will normally be the managing partner in the venture, but the bank may participate in the management and thus be able to monitor the use of the funds more closely. Typically, a diminishing musharakah will be used for this purpose, and the customer will progressively purchase the bank’s share of the venture. Operational risks that may be associated with musharakah investments are as follows:
5.6 Mudarabah
Mudarabah is a profit-sharing and loss-bearing contract, under which the financier (rab al mal) entrusts his funds to an entrepreneur (mudarib). Since this type of contract may be used on the assets side of the balance sheet, as well as being used on the funding side for mobilizing investment accounts, the operational risk is first analyzed from the assets-side perspective and then from the funding-side perspective (which is related to fiduciary risk).
In return, the Islamic bank has fiduciary responsibilities in managing the IAHs’ funds. The IAHs typically expect returns on their funds that are comparable to the returns paid by competitors (both other Islamic banks and conventional institutions), but they also expect the Islamic bank to comply with Shari’ah rules and principles at all times. If the Islamic bank is seen to be deficient in its Shari’ah compliance, it is exposed to the risk of IAHs withdrawing their funds and, in serious cases, of being accused of misconduct and negligence. In the latter case, the funds of the IAHs may be considered to be a liability of the Islamic bank, thus jeopardising its solvency.
5.7 Sukuk Securitisation
Sukuk securitisation is the financial engineering process for the creation and issuance of sukuk, where payment of principal and profits are derived from the cash flows generated from the underlying assets in the securitisation. Asset-backed sukuk securitisations (see below) include the process whereby ownership of the underlying assets is transferred to a large number of sukuk investors via a special purpose entity (SPE). The IFSB’s Exposure Draft3 categories two types of sukuk structures:
5.8 Real Estate Investment
Conventional financial institutions in general cannot engage in real estate investments unless they obtain consent from the regulatory authority. These institutions are required to comply with applicable capital standards, and the authority determines that the activity poses no significant risk to the depositors. They also need to have an adequate risk management process in place, and the overall financial conditions (including capital requirements) should be able to withstand potential risk associated with the holding of investment or financing property. In most instances, the authorities require conventional institutions to establish a subsidiary or dedicated branch to conduct the real estate activities, so as to place these activities in a separate corporate entity and thus not expose their depositors to the risks of such investments.
The construction boom in the some Gulf Cooperation Council countries reveals that that it is common to find Islamic banks that have half of their assets linked to real estate, to the extent that these Islamic banks are exposed to the real estate sector, through musharakah and istisna’a contracts.4
Unlike conventional banks, real estate exposure for Islamic banks does not come in the form of a loan. Instead, the exposure typically takes the form of a profit-sharing contract—Islamic banks put their capital at risk in the form, effectively, of an equity stake. It may not have the same kind of direct management involvement that a private equity firm would and, as such, an Islamic bank’s exposure depends on both the skill and honesty of its partner. Islamic banks may also act as property co-developers and/or then co-owners, an activity normally undertaken by real estate specialists.
Such types of real estate activities raise supervisory issues, particularly with respect to risk management, capital adequacy, and transparency, especially during economic downturns. These are certainly the areas that need greater scrutiny—in fact, because the real estate assets the Islamic banks are financing continue to be owned by their clients, much Islamic bank exposure to real estate risk may not appear on the sector’s balance sheets. In addition, real estate risk concentrations are also common among Islamic banks—their geographic reach tends to be limited, as are the types of assets they are able to accept. Hedging, including risk transfer through securitisation, is mostly limited.
Briefly, sources of operational risk related to real estate can be viewed from two angles, namely, the strategic level and the impairment of real estate. While strategic risk is not considered as part of the operational risk under the definition of the operational risk, an Islamic bank needs to be critical regarding the creation of value. The potential for structural failure of a key facility could create operational risk.
The other potential operational risk is on the impairment of such real estate. The potential for the decline (or increase) in the value of real estate assets is driven by both the property market and its regional and national economy. Properties whose market value is below book value are common in the corporate world. Recognition through write-downs may impede the execution of strategy by adversely affecting credit ratings and analysts’ outlook for public companies. Similarly, especially when operating in less mature markets, property values can be impacted not only by rapid currency shifts but also by a change in policy by a national government. Hence, exposures to property market and economic/political risks are often unpredictable.
Another source of asset impairment risk is related to the intangible value created by the corporate real estate. Properties often carry an organisation’s brand, especially in the retail and leisure sectors. A lack of investment in these facilities can undermine the brand and reduce the value of the organisation. Additionally, the workplace is often a key symbol in creating corporate culture and any misalignment between the corporate mission and the working environment can also impede the implementation of strategy. In the retail sector, successive format shifts or innovations cause obsolescence in existing stores without any change in the physical condition or the surrounding market.
The other source of asset impairment relates to physical damage to an asset. Property assets are exposed to fire, floods, terrorist attacks, and other catastrophes. The real estate manager must assess these risks in each situation, determining the extent to which on the one hand they are likely to occur and on the other hand whether the facility houses operations that affect the business value. Islamic banks may insure themselves against many of these risks, but they also need to develop contingency plans for rehousing the critical operations.
In certain jurisdictions, the supervisory authorities provide more detailed and specific guidance on the definition and classification of permitted real estate activities. In recent years, many supervisory authorities have been quite proactive in supervising the real estate portfolios of Islamic banks in their jurisdictions and, thus, have updated their regulations and guidelines to align with the rapidly changing market realities.
6. QARD
Qard is a loan given by an Islamic bank (or other lender), such that the borrower is contractually obliged to repay only the principal amount borrowed. In the contract of qard, no additional payment other than the principal amount lent can be required, as that would be a form of riba. If a fixed period of repayment is stipulated in the contract, the borrower is liable to pay back the principal amount to the lender on or before the agreed date of payment. On the other hand, if no period is stipulated in the contract, it is binding upon the borrower to make a repayment of the loaned amount to the lender on demand. Islamic banks provide financing to their customers as financial intermediaries and seek opportunities to earn profits for their shareholders and fund providers. Therefore, most Islamic banks will not provide any significant amount of lending on the basis of qard, as Shari’ah rules and principles require the borrower to pay only the principal amount in that case. The main category of risk related to qard can be considered as credit risk. However, from the operational risk perspective, an Islamic bank is exposed to the strategic decision on how much the management is willing to allocate to such contracts (as part of meeting their social obligations) given that no financial benefits can be generated from such financing.
6.1 Wakalah
In an asset-side wakalah contract, an Islamic bank assumes the role of a principal (muwakkil) and appoints the customer as agent (wakeel) to carry out a specified set of services or act on its behalf. This section is applicable to both restricted and unrestricted wakalah financing. Wakalah is a contract of agency whereby one person contracts to perform any work or provide any service on behalf of another person. Businesses rely on a range of individuals to act on their behalf, and these include employees, directors, and partners as well as a range of professional agents. An action performed by an agent on behalf of the principal will be deemed to be an action by the principal. An agent will obtain a payment wage for services rendered according to the contractual reward structure offered by the principal, which may incorporate a performance-related element.
The Islamic bank as principal (muwakkil) is exposed to the risk of losing its invested capital (i.e., capital impairment risk). Any loss on the investment is to be borne solely by the muwakkil, but is limited to the amount of its capital. Losses that are due to fraud, misconduct, negligence, or breach of contractual terms are to be borne by the wakeel. Therefore, the Islamic bank is exposed to the skills of the wakeel that manages the investments on behalf of the bank as well as business risks associated with the underlying activities and types of investments or assets of the wakalah agreement.
6.2 Impacts of Current Regulatory Development on Operational and Other Aspects of Risk Management
As can be seen from the above explanations, Islamic banks are still exposed to credit, market, operational, and reputational risks similar to those of conventional banks. Islamic banks face unique challenges, however, in managing liquidity. Given the restricted range of instruments to manage the liquidity requirements, an Islamic bank needs to manage its innovative risk management and compliance so that all relevant staff involved in the process will be fully aware of the risks that may emerge from such a situation. An Islamic bank is also expected to run stringent stress testing and scenario analysis to avert potential liquidity problems.
In this respect, the IFSB has issued a number of standards as well as others in the pipeline designed to complement the work of other international standards. The works include:
- Identify how different portfolios respond to changes in key economic variables (e.g., benchmark rates, foreign exchange rates, credit quality, etc.).
- Monitor the quality of assets to identify existing and potential loss exposures.
- Evaluate potential threats to the Islamic bank’s ability to meet its financial obligations at any time arising from either funding or market liquidity exposures.
- Estimate the impact of stress events on baseline profit (as profits normally act as the first line of defence before dipping into capital).
- Analyse the Islamic bank’s ability to meet its capital requirements at all times throughout a reasonably severe economic recession.
For supervisory authorities, stress testing can be used (i) as a surveillance tool for periodically testing the safety and soundness of the financial system, and (ii) from a financial stability perspective, to identify “weaknesses” in the financial system and structural (systemic) vulnerabilities arising from the specific risk profiles of Islamic banks individually and collectively.
7. CONCLUDING REMARKS
In summary, the current regulatory requirements are likely to have impacts on the IT systems of Islamic banks as well as on their operations. With regard to IT-related matters, institutions are expected to manage the monitoring of their liquidity risk very closely. The computation of the abovementioned ratios has to be addressed in advance of the actual implementation that will take place over the next few years. Emerging from such requirements is the need for more comprehensive reporting to both regulatory authorities and the public. As a result, the new processes and procedures, as well as reporting and disclosures, will be expected to improve over time. The indirect impacts on the staff training and skills will also increase the challenge to Islamic banks, because regulatory changes to implement Basel III will be of a more dynamic nature as it comes in stages.
It will be apparent from the above that Islamic banks are exposed to a number of operational risks that are somewhat different from those faced by conventional banks. The relative complexity of a number of their products, as well as their relative novelty in the contemporary financial services market, including sukuk securitisations and real estate investment, combined with the fiduciary obligations of an Islamic bank when its acts as a mudarib, imply that for Islamic banks operational risk is a very important consideration.
For these reasons, the IFSB has taken the position that, while IAHs may be considered (in the absence of misconduct and negligence by the Islamic bank) to bear the credit and market risks of assets in which their funds have been invested by the bank, the latter must be considered as being exposed to the operational risk arising from its management of those funds. The new developments taking place in IFSB standards and guidelines require Islamic banks to revisit their operational requirements, as they must ensure that they have the processes in place to remain compliant and at the same time profitable.
NOTES
1. This standard is currently in the course of revision, but the revisions do not affect the treatment of operational risk, except that an Alternative Standardised Approach (ASA) is included. Under ASA, the operational risk capital charge is calculated in the same way as under TSA, except for two business lines (i.e., retail banking and commercial banking). For these two business lines, instead of using relevant gross profit, the amount of financing in each LOB is multiplied with a fixed factor of 0.035 to obtain the indicator of exposure.
2. When two istisna’a contracts are entered into back-to-back, one of them is referred to as a parallel istisna’a contract. Commonly, the contract that is entered into second (chronologically) is considered to be the parallel istisna’a contract.
3. IFSB Exposure Draft on Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services [Excluding Islamic Insurance (Takāful) Institutions and Islamic Collective Investment Schemes] Nov 2012.
4. PricewaterhouseCoopers, “Growing Pains: Managing Islamic Banking Risks,” 2008, www.pwc.com/en_GX/gx/financial-services/pdf/growing_pains.pdf.