Risk Management and Liquidity in Islamic Banking - A Regulators Perspective

Duncan Smith

Risk Management and Liquidity in Islamic Banking - A Regulators Perspective
New Horizon, No 111, August 2001, pg 3-5
- By Duncan Smith


Introductory comments made by DUNCAN SMITH of ABCIB Islamic Asset Management Ltd, chairing the FSA Lecture on Risk Management and liquidity, at IIBI, on 26th June 2001

Two main topics are the subject of this very important lecture: Risk Management - assessing, pricing, mitigating and, controlling risk.

It is fair to say that this has not been an area where most Islamic Banks have excelled over the last 20 years. There have been major issues across the Arab world — from Egypt to Kuwait, Qatar and Dubai over into Africa and eastwards into the subcontinent since Islamic Banking first became established Risks — operating, credits, regulatory — if we are honest with ourselves have frequently been ill understood and worse managed.

But let me also say here, that during this period we have also had even more spectacular problems in the conventional banking sector. The Savings & Loans problems in the USA, bank failures and constructive failures in Europe, regular collapses in the world’s conventional credit markets and a derivatives market with risks which it seems to me are imperfectly understood both by those who run the banks and quite probably by those that supervise them. These are a small selection of conventional banking’s own ‘major issues’ over the same period.

I make these points because risk management is not just a hot topic in Islamic Banking, it is a huge issue for all banks whether Islamic or not and for those who supervise those banks Thus, in the same way as Islamic Banks need the right, technically competent analysts and managers running their risks, so do non-Islamic institutions. What I am coming round to say, is that good risk management practice and process does not have a religion or a color or a country. There are plenty of good risk takers in Islamic Banks and some bad ones. It is the same in the conventional banking sector.

Liquidity — here we get into a whole raft of additional complexities which do not exist in conventional markets — specifically we get into the area of Shariah compatibility and Shariah compliance. In the interests of brevity let me try to articulate succinctly what — I think and most of us know — the issue is.

a)      Firstly, Islamic Banks funding comes from customer (i.e. personal customer) accounts, the vast majority of which are on call or very short notice.

b) Secondly, because hedging the market rate risk using conventional means is not in compliance with Shari’s and there is no central   receiver and provider of liquidity to and from the Islamic Banking market, Islamic Banks need to match their short term customer deposits with short term, low risk assets

c)   Thirdly, for the last twenty years many of these assets have come from the short term bank guaranteed murabaha markets where there is appetite for attractively priced funding

d)  And, lastly, the resulting debts (in sharp contrast to the conventional market) are not       (largely) tradable.

I think we all know the question which follows from the resulting potential for asset and liability mismatches… so… What is the answer?

I suppose the greatest possibility going forward will be the wide development first of Islamic securities and then a market in them. This market will in time absorb funding from the short—term murabaha markets into asset—backed and business-backed securities with defined, well – rated returns. The first issues of securities are, however, only now taking place and I would guess it will be another 3 years before any significant inroads are made into the dominance of the short term sales related debt contract.

Risk Management and Liquidity in Islamic banking — A Regulators Perspective


By TOBY FIENNES, Manager, and Charles Plowden, Associate, Middle East and Levant Group, Financial Services Authority, London, UK



Risk management and liquidity are of crucial importance in the overall banking environment, and they have clear relevance also to the specific environment of Islamic banking. In itself, Islamic banking is of growing significance. Regulators have their own particular perspective on these issues, as elaborated on in this article.

As a regulator based in London the FSA should focus on the following:

a) The importance of London as a centre of Islamic financing.

b) The overall role of the FSA as a regulator — why sound regulation is of critical importance in any financial marketplace, how it can assist in facilitating competition and innovation.

c) Risk management issues in banking: a summary of the key elements involved.

d) Risk management and liquidity issues as applied to Islamic banking.

e) The perspective of the regulator, and why the UK operates a single regulatory framework for all firms.

The importance of London as a centre of Islamic financing.

London is clearly one of the pre eminent centres of Islamic finance, for two main reasons. These are the presence of sizeable Muslim community in the UK; and the importance of London as a financial centre with the expertise to develop new and innovative products. The FSA as Regulator welcomes the development of Islamic finance, and would be happy to see this grow further. Other important centres include Bahrain and Malaysia.

London plays a role in four areas of significance in Islamic banking:


• Trade assets such as murabaha, istisna’a, and bai-al-salam. The market is probably worth US$ 10 billion in the UK.

• Equipment leasing - asset and partner selection, operating leases and finance leases

• Real estate - where investors are looking for rental and capital benefits. Investment routes include fund management, club transactions, leverage funding, and asset analysis, corporate structuring and tax planning.

• Packaging and delivering assets engineering solutions. This includes a growing market in securitizations of pools of Shariah compliant assets.

The role of the FSA as a regulator

The Government has set the FSA four objectives:

• Market confidence

• Public awareness of the financial system

• Consumer protection

• Reducing financial crime

The new FSMA will bring in eleven principles for the handling of business, which set out at a high level how we expect a firm and its management to conduct themselves. In terms of minimum criteria, the FSA has to be satisfied that institutions have adequate capital, adequate liquidity and adequate control over large exposures. Banks of what ever origin must be prudently run and that their management must be fit and proper for the task. Satisfactory risk management, a realistic business plan, and adequate systems and controls need to be clearly demonstrated. The FSA must be satisfied also that each institution is subject to effective consolidated supervision – i.e., that one supervisory authority takes prime responsibility for supervising the bank or banking group as a whole.

Risk management issues in banking

Senior management in any business must be able to provide effective risk management. The consequences of failure to do so are dire, for example, the collapse of Barings where proper controls and monitoring were not effectively in place:

Regulators need to be sure that such risks are managed so as to prevent a worst case scenario such as the systemic collapse of a whole banking system. Critical issues for Islamic banks are the reputational risks and legal risks of non-compliance from Shariah board requirements and/or from engaging in any activities that were not perceived as properly Islamic by the marketplace. The maintenance of trust amongst Islamic market participants is crucial.

• Credit risk

This is the risk that customers default and cannot service their debts. Banks can also suffer from the excessive concentration of exposures to particular customers, industries or countries. Asset quality should be closely monitored using appropriate management information and systems support. Islamic banks run an asset book, just as conventional banks do, so the same disciplines must apply.

• Liquidity risk.

Banks face collapse or severe trading difficulties when they are unable to meet their liabilities. For example, many Japanese institutions operating in London in the late l990s were hit when the Japanese premium increased their funding costs and eroded their liquidity. This did not mean, however, that they became unable to meet their liabilities. For the FSA, liquidity is a key concern. The dilemma for the Islamic sector is that liquidity from the Gulf is currently very substantial, but there is the need to seek out appropriate outlets for it. There is not a clearly defined lender of last resort for Islamic banks that might suffer liquidity problems, although support could probably be found from with in the overall pool of liquidity.

* Interest rate risk

The risk of declines in earnings due to the movement of interest rates. Most of the balance sheet items of banks generate revenues and costs that are indexed to interest rates. A key aspect of interest rate risk is also the possible mismatches that can arise between fixed and floating rates. In the Islamic banking context, interest rates per se are not a factor. However, commissions generated on Islamic transactions could also be vulnerable to market movements.

• Market risk

The risk of adverse deviations of the mark-to-market value of the trading portfolio during the period required to liquidate the transactions. Islamic financial institutions take up “risk sharing” funds, whereas conventional banks take “capital certain” deposits where repayment must be made. There is the implicit requirement for both parties to a given transaction to share in the loss as well as the profit.

• Foreign exchange risk

The currency risk of suffering losses due to changes in exchange rates. This principle applies equally to Islamic banks. Letter of credit and trade finance for example, a significant proportion of which is denominated in US Dollars, often pose an exchange risk. Currency transaction and translation Factors must be taken into account.

• Solvency risk

The risk that financial institutions will be unable to hold sufficient capital resources to cover their different risks. Regulators need to decide what amount be held, supervise, in order to maintain an appropriate level of solvency. Islamic banks need to be clear about the status of their deposits or liabilities. Any “capital-certain” transactions generate more solvency risk than risk-sharing with investors.

• Operational risk

There is no precise definition, but we view operational risk as being the risk that arises from human error and/or deficiencies in information systems or controls, resulting in direct or indirect loss. In the Islamic banking context, operational risks can impact just as much as in conventional banking, with the additional element of possible operational defects causing failure to comply with the Shariah.

Risk management and liquidity issues as applied to Islamic banking

This is a very important area and a number of key regulatory issues are under review. For example, whether liquidity requirements should apply to all on-balance sheet funds, risk sharing as well as capital certain; and how liquidity should be managed for funds, which are held off balance sheet. The basic issue, however, as for any bank is how easily and quickly, and with what penalty, assets can be turned into cash.

The establishment of a genuine interbank market or markets would be a significant step towards providing Islamic banks with the ability to maintain adequate liquidity without holding excessive amounts of very short-term assets. For example, it was very interesting to note that the       Bahrain Monetary Authority (BMA)       announced the first issue of its Islamically-structured bonds - the Sukuk al-Salaam - worth US$ 25mn. ABC Clearing Company BC and ABC Islamic Bank have been active in offering overnight investment opportunities for Islamic funds for a number of years.                               

                BNP Paribas and Kuwait Finance House signed a memorandum of understanding for the creation of a US$ 2bn Islamic money market fund (IMMF). Bank of America, Deutsche Bank, and ABN AMRO also plan to launch such instruments. Malaysia has also been developing an Islamic interbank market.

These developments offer potential flexibility to Islamic banks. UK practice is such that the FSA has scope to take account of such developments when agreeing liquidity guidelines with banks.

The perspective of the Regulator

The fundamental stance of the regulator is that the same principles in the handling of risk should apply for Islamic as for non-Islamic banks and financial entities. There has to be a level playing field.

For the regulator, risk management in the Islamic context is becoming easier to understand as the following develop:

• A set of common international equivalent accounting standards. The AAOIFI is doing a lot of good work in this area but we need to see more harmonization.

                • Greater standardization of products.

• A clear role for the Shariah Board. For example, if there were to be one Board per country it should assist in giving consistency of interpretation of the Shariah.

                The FSA has had no applications for authorization from purely Islamic banks. If an application were to be made, it would be considered against our minimum criteria and principles for business. For us, an important aspect of any application would be the effectiveness of the applicant’s risk management systems and controls.

                — Paper presented at a seminar at the Institute of Islamic Banking and Insurance, on Tuesday 26th June, 2001








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