Risk management tools practiced in Islamic banks ...

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Risk management tools practiced in Islamic banks: evidence in MENA region Rim Ben Selma Mokni

Risk management tools 77

Faculty of Management Sciences and Economics, El-Manar University, Tunis, Tunisia

Abdelghani Echchabi International Islamic University Malaysia, Kuala Lumpur, Malaysia

Dhekra Azouzi Faculty of Management Sciences and Economics, El-Manar University, Tunis, Tunisia, and

Houssem Rachdi Faculty of Law, Economics and Management of Jendouba, University of Jendouba, Jendouba, Tunisia Abstract Purpose – The main purpose of this study is to investigate in detail the way each risk is being measured and managed by Islamic banks in the MENA region. Design/methodology/approach – This research attempts to examine the perceptions of Islamic bankers about the importance of transparency and public disclosure in the understanding of the bank’s risk profile. It covers 23 Islamic banks located in the MENA region using self-administered questionnaire. Findings – The results show that there are differences in the level of risk perception across funding modes. Also Islamic banks use extensively the traditional tools in mitigating risk. Practical implications – The paper discusses and analyses the current practices employed in the risk management of Islamic banks. It identifies the tools and methods used in managing credit risk, market risk, liquidity risk and operational risk by Islamic banks. Originality/value – This study aims to extend the existing literature in two ways. First, this paper contributes to the dearth of studies on examination of tools practiced in the risk management by Islamic banks located in the MENA region. Next, this work integrates the methods used in the management of liquidity risk that have not been studied earlier. Keywords Risk management, Islamic banks, MENA region, Risk management practices Paper type Research paper

1. Introduction Risk management is a core activity of every financial institution; it involves identification, measurement, monitoring and controlling risks. Hence, it is imperative on the risk manager to have a comprehensive understanding of the risk and the measurement of the risk exposure in order to effectively carry the tasks entrusted on him. Moreover, risk management serves as means of checking if decisions taken regarding risk are in accordance with the business strategy and objectives. Risk management in banking designates the entire set of risk management processes and

Journal of Islamic Accounting and Business Research Vol. 5 No. 1, 2014 pp. 77-97 q Emerald Group Publishing Limited 1759-0817 DOI 10.1108/JIABR-10-2012-0070

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models upon which, risk-based policies and practices are determined. The spectrum of models and processes encompasses all risks: credit risk, market risk, interest rate risk, liquidity risk and operational risk. Banking operation revolves around risk management. As such banks are considered “risk machines” based on the fact that, they take risks, transform them, and they embed them in banking products and services (Arora and Agarwal, 2009). Risk management is therefore a continuous and vigilant process for the banks. Banks must always be proactive and put in place and effectively managing the inherent risk associated with banking business. The goal of an effective risk management system is not only to avoid financial losses, but also to ensure that the bank achieves its financial results with a high degree of reliability and consistency. It thus serves as a pre-requisite for the soundness, stability and sustainability of any financial institutions (Khan and Muljawan, 2006). Islamic financial institutions have been established four decades ago as an alternative to conventional financial institutions primarily to provide investment, financing and transactions compatible with Shari’ah. The fast expansion of the Islamic financial industry reflects its systemic importance for the global financial system. The future and sustainable of these institutions lie on their ability to cope with the rapidly changing of the landscape of the financial system. Islamic financial institutions need to be well equipped in term of latest risk management skills and operational systems to withstand the challenges poses by the current financial system environment. Identifying how these institutions manage the inherent risk of Islamic financial services could go a long way in ensuring a sustainable growth and survival of the industry. The present paper thus discusses and analyses the current risk management practices by Islamic banks in the Middle East and North Africa (MENA) region. It identifies the tools and methods used in managing credit risk, market risk, liquidity risk and operational risk by Islamic banks. As such, this study is aimed at examining the extent to which Islamic banks implement some aspects and methodologies of credit risk management, market risk management, operational risk management and liquidity risk management. Expectedly, this study could potentially extend the existing literature in two ways. First, it makes significant contribution to the dearth of studies on the risk management practice of the Islamic banks located in the MENA region. Second, this work integrates the methods used in the management of liquidity risk that has received little or no attention in the previous literatures. The next section presents the relevant literature on issues pertaining to risk management practices. Section 3 focuses on the methodology and is followed by Section 4, which presents the main empirical findings and discusses the results. Finally, Section 5 presents the summary and the conclusion. 2. Literature review The role of financial system irrespective of conventional or Islamic is the mobilisation and allocation of financial resources across various available investments. Islamic banking has been growing at a rapid pace since its introduction about four decades ago and currently considered as an alternative approach to conventional banking system. The approach of Islamic banking system is based on a number of rules and regulations derived from Islamic law or shari’ah. Particularly, Islamic banking has a distinct philosophy, based on Islamic principles of social justice, fairness and equity.

Contemporary Islamic banking system is relatively new compared to its conventional counterpart and it encompasses economics, ethics and Islamic law of transactions which takes its source from the shari’ah. It basically serves the same purpose as conventional banking with the exception that it operates solely in accordance with the principles of shari’ah. Islamic banking strongly prohibits interest, gharar, and requires all transactions to be legal (halal) (Archer and Karim, 2001). Islamic banks and other Islamic institutions offering financial services receive deposits and conduct most of the common banking activities with the exception of the loan transactions or interest-based loans (Al-Jarhi and Iqbal, 2001). Furthermore, Islamic banks are considered direct investors rather than mere financial intermediaries. Specifically, Islamic banking operations are based on the principle of profit and loss sharing, in the sense that the associated risk is not only bore by the customers but shared by both parties. This quit different form the conventional banking system where the risk and loss are borne solely by the customers in the traditional single lender-borrower relationship. Hence, the relationship between creditor/debtor as observed in conventional economy is redefined in Islam financial system (Grassa, 2012) whereby the creditor or the banks is regarded as a partner in the project and share in the profit or loss. At the organizational level, Islamic banks are characterized by the existence of a committee of shari’ah commonly called shari’ah supervisory boards (SSB) or shari’ah advisory boards (SAB). The main roles of the SSBs are: . to certify the financial products offered by the Islamic institutions based on the legal Islamic sources; . to verify that the practical transactions are in line with the approved instruments; . to calculate and ensure the smooth payment and distribution of zakat; . to dispose non-shari’ah compliant earnings; and . to advise the concerned institutions on the distribution of incomes and expenses (Grais and Pellegrini, 2006). These distinct features of Islamic banks thus exposed it to certain unique risks. Khan and Ahmed (2001) argued that Islamic banks face not only the same risks as conventional banks but also “new and unique risks as a result of their unique asset and liability structures”, i.e. Shari’ah non-compliance risk, product/mode of financing risk, process risk, counterparty risk, etc. Risk management in banks has attracted the attention of researchers and in the last few years, a number of studies have looked at the practice of risk management within the corporate and banking sector. Islamic banking has witnessed astronomical growth nowadays, nonetheless, the extant literatures that focus on risk management is limited. Below are review and opinion of some selected studies. Al-Tamimi (2008) studied the relationship between the readiness of implementing Basel II Accord and resources needed for its implementation in UAE banks. The findings revealed that UAE banks are ready to implement Basel II. No significant difference was found in the level of Basel II Accord’s preparation between the UAE national and foreign banks. Hence, it was concluded that there was a significant


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difference in the level of the UAE banks Basel II based on the level of education of the employee. The results collaborate the importance of training and educational level needed for the implementation of Basel II Accord. The relationship between readiness and anticipated cost of implementation was also not confirmed. In a related study, Khan and Ahmed (2001) investigated risk management practices in 17 Islamic financial institutions across ten countries based on field survey. The results revealed the bankers’ perspectives regarding different risks and issues related to the risk management process in Islamic financial institutions. They indicated that Islamic financial institutions face some risks arising from profit sharing investment deposits that are different from those faced by the conventional financial institutions. The result of the survey showed that Islamic bankers rated profit sharing modes of financing (diminishing Musharakah, Musharakah and Mudharabah) and product-deferred sale (Salam and Istisna’) as riskier than Murabahah and Ijarah. The results thus revealed that, Islamic bankers rank the mark-up (interest rate) risk as the most critical risk they face followed by the operational risk and the liquidity risk. Credit risk which is the risk that most financial institutions deal with are not considered as severe as these risks. Market risk is however regarded as the least risk face by Islamic banks The reasons for considering mark-up risk as the highest may be due to the risk generated from Murabahah contract which cannot be hedged using conventional banking tools such as interest rate swap and other derivatives tools which obstruct risk management in Islamic financial institutions. According to Hassan (2009), the three most important types of risk facing Islamic banks in Brunei Darussalam are the foreign-exchange risk followed by the credit risk and then the operational risk. Regarding the most important methods used by Islamic bankers in risk identification, the results revealed that inspection by Shari’ah supervisors, executive and supervisory staff, audit and physical inspection, financial statement analysis and risk survey are the most significant factors of risk identification. It also indicated that, Islamic banks in Brunei Darussalam are reasonably efficient in risk assessment and analysis, risk management, risk identification and less efficient in credit risk management. Arrifin et al. (2008) revealed that Islamic banks are typically exposed to the same types of risks as conventional banks, but with different levels of the risks; Islamic banks are perceived to be employing less technically advanced risk measurement techniques compared to the most commonly used such as maturity matching, gap analysis and credit ratings. The more technically advanced risk measurement techniques, which include VaR, simulation techniques, estimates of worst case and RAROC, are perceived not widely used by Islamic banks in the study. The main explanation for this is that Islamic banks are still new and do not have sufficient resources and systems to use more technically advanced techniques. Hassan (2011) examined the extent of risk management practices and techniques by Islamic and conventional banks in term of dealing with different types of risks in the Middle East region. The author equally sought to identify the peculiar types of risk facing Islamic and conventional banks in the Middle East. The result of the survey administered on 19 Islamic banks and 24 conventional banks indicate a positive relationship between risk management practices and understanding risk, risk management, risk identification, risk assessment and analysis, risk monitoring, and credit risk analysis in Islamic and conventional banks. It also revealed significant

differences between Islamic and conventional banks regarding risk assessment and analysis, risk monitoring, risk management practices and credit risk analysis. As indicated in the finding, the most important type of risk facing Islamic banks is interest rate risk. Even though Islamic financial institutions do not deal with interest rate, they apply it in the market as a benchmark to price certain types of financing products such as Murabahah and Mudharabah. This is due to the fact that, they cannot re-price Mudharabah and Murabahah contracts. In addition, Islamic banks cannot engage in interest rate swap contracts to hedge this type of risk because an instrument such as derivative contracts is totally prohibited. The second type of risk facing Islamic banks is credit risk followed by operational risk and currency risk. Khalid and Amjad (2012) conducted a research on the risk management in Islamic banking in Pakistan. The authors used the same model suggested by Al-Tamimi and Al-Mazrooei (2007) of risk management practices. The results indicated that, understanding risk and risk management, risk monitoring and credit risk analysis significantly contribute to the ability of the Islamic banks to efficiently managing their risk. Using a survey method involving 136 observation to examine the impact of the risk management process on the level of risk management practices in Islamic banks for the case of Malaysia and Egypt, Abdul Rahman et al. (2013) indicated that the ability to properly understand, identify, assess, analyze, control and monitor risk contribute to efficient risk management process in these countries. Such tasks are thus extremely important since the risks faced by Islamic banks have significant impacts on their efficiencies (Said, 2013). 3. Methodology This study aims at identifying the tools and methods used in managing credit risk, market risk, liquidity risk and operational risk in Islamic banks. In addressing those issues, this study adopts the methodology based on works of Tafri et al. (2011) and Arifin et al. (2008). 3.1 Instrument This study covers 23 Islamic banks located in MENA region using a survey questionnaire to obtain the perceptions of risk managers about some of the issues related to risk management of Islamic banks. Basically we focus more on the nature of risks, risk measurement and risk management techniques in Islamic banks. Following the works of Arifin et al. (2008), Tafri et al. (2011), Khan and Ahmed (2001), Deloitte Touche Tohmastu (2004, 2007, 2009, 2011) and KPMG (2004), a five-point scale, closed-ended questionnaire was developed. Section I of the questionnaire is aimed at capturing the perceptions of risk managers about the nature of risks associated with each financing mode. Sections II, III, VI and V address information related to the tools and techniques used in managing credit risk, market risk, operational risk and liquidity risk, respectively. Section IV is intended to point out the importance of market discipline in Islamic banks. 3.2 Sample and data collection For banks located outside Tunisia, the risk managers were alerted of the availability of the questionnaire using survey monkey. For the two Islamic banks located in Tunisia,


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the questionnaire was self-administered. The list of Islamic banks was taken from the International Directory of Islamic Financial Institutions (IDIFI) issued by the Institute of Islamic Banking and Insurance (IIBI) in London. The sample for MENA countries used in the study are: Bahrain, Jordan, Kuwait, Lebanon, Qatar, Saudi Arabia, United Arab Emirates (UAE), Algeria, Tunisia and Egypt. Hence, the sample represents all the main MENA sub-regions, namely, GCC, North Africa and the Levant region. The total number of questionnaires distributed was 36 out of which 26 responses were received. Eventually, only 23 Islamic banks have been completely responded to the questionnaire. Hence, a response rate of nearly 64 per cent was achieved. 4. Findings This section presents the findings obtained from the questionnaire survey. These results are discussed in sub-section 4.6 based on the following: risk perceptions, credit risk management, market risk management, operational risk management, liquidity risk management and transparency and market discipline. 4.1 Risk perceptions This section reports some perspectives of Islamic bankers regarding the risks that their institutions face. The five point-Likert scale used in the questionnaire to ascertain the Islamic bankers’ perceptions of the importance of risks in Islamic banks is presented in Table I. Table II summarises the risk managers’ perceptions of the risk for different modes of financing. It is indicated that the means are between 3.64 and 4.28. The mean values and Friedman mean ranks further revealed that, Islamic bankers classify liquidity risk as the most important followed by Shari’ah non-compliance risk and credit risk. Market risk however got the lowest ranking under Islamic banks. Though these results

Table I. Scale for the importance of the risks in Islamic banks

Scale

Classification

1 2 3 4 5

Very unimportant Unimportant Neutral Important Very important

Risk

Table II. Descriptive statistics and Friedman test for each type of risks (overall)

Credit risk Rate of return risk Market risk Liquidity risk Foreign exchange rate risk Operational risk Shari’ah non-compliance risk

Mean Mean rank 4.04 3.88 3.64 4.28 3.76 3.88 4.08

4.20 3.70 3.48 4.66 3.80 3.84 4.32

Note: Significant at: *10, * *5 and * * *1 per cent

Ranks through Friedman test 3 6 7 1 5 4 2

Skewness x2 (asymp. sig.) 21.537 20.427 20.449 21.381 21.092 21.137 21.543

0.000 * 0.155 0.107 0.002 * 0.003 * 0.003 * 0.000 *

shed more light on the perception regarding risk of Islamic banks by risk managers, it is worth noting that the difference is not statistically significant. This is shown by both Friedman test as well as the paired sample test in Table III. The latter have been identified based on the Friedman ranking results. Hence, it can be concluded that the Islamic banks’ managers are indifferent between the various types of risk mentioned above. This result may be explained in term of the under-developed Shari’ah-compatible money market and interbank market, limitation of financial instruments that can be traded in the secondary market. The typical liquidity management tool available to conventional banks such as the interbank market, secondary market for debt instruments, and discount windows from the lender of last resort (central bank) are all linked with riba (interest); hence, prohibited under Islamic finance. Furthermore, Islamic banks hold a considerable proportion of funds in the form of demand deposits in current accounts which can be withdrawn at any time. Besides, we attempt to evaluate the risk perceptions of the Islamic bankers for different modes of financing. The mean values as presented in Table IV indicated that Murabahah is perceived as the riskiest among the selected modes of financing, while diminishing Musharakah is considered the least risky among them. For further validation, Friedman test as well as paired sample tests were applied. The Friedman test results in Table IV indicated that Murabahah is perceived as the riskiest mode of financing, followed by Diminishing Musharakah, Mudharabah, Salam and Musharakah, Istisna’ then Ijarah,, respectively. Though the test provided an insight on the risk perception based on ranking, the result was not statistically significant. Hence, it is necessary to conduct a paired comparison of the various modes

Mean Pair 1

Pair 2

Pair 3 Pair 4

Pair 5

Pair 6

Paired differences 95% confidence interval of the difference SD SE mean Lower Upper

Liquidity risk0.200 1.041 Shari’ah noncompliance risk Shari’ah non0.040 1.274 compliance riskcredit risk Credit risk0.160 0.554 operational risk Operational risk0.120 0.881 foreign exchange rate risk Foreign 20.120 0.927 exchange rate risk-rate of return risk Rate of return 0.240 1.128 risk-market risk

t


Sig. Df (two-tailed)

0.208

20.230

0.630

0.961 24

0.346

0.255

20.486

0.566

0.157 24

0.877

0.111

20.069

0.389

1.445 24

0.161

0.176

20.244

0.484

0.681 24

0.503

0.185

20.503

0.263 20.647 24

0.524

0.226

20.226

0.706

0.298

1.063 24

Table III. Paired samples test for the various types of risk

Table IV. Risk perception in different modes of financing (mean values)

Note: Significant at: *10, * *5 and * * *1 per cent

0.000 *

4.04 3.88 3.64 4.28 3.76 3.88 4.08 3.94

4.24 3.88 3.61 3.96 3.76 3.88 4.25 3.94 4.94 1 0.000 *

Murabahah 4.14 3.71 3.33 3.47 3.67 3.56 4.24 3.73 4.19 4 0.047 * *

Salam 3.74 3.78 3.33 3.63 3.65 3.84 4.22 3.74 3.56 6 0.016 * *

Istisna’ 3.96 3.52 3.3 3.54 3.61 3.68 3.58 3.6 2.25 7 0.233

Ijarah 4 3.71 3.58 3.72 3.67 3.91 3.87 3.78 4.38 3 0.014 * *

Mudharabah

4 3.88 3.26 3.54 3.5 3.46 3.65 3.61 4.19 4 0.050 * * *

Musharakah

4 3.72 3.22 3.56 3.38 3.46 3.82 3.59 4.5 2 0.030 * *

Diminishing Musharakah

84

Credit risk Rate of return risk Market risk Liquidity risk Foreign exchange risk Operational risk Shari’ah non-compliance risk Total Mean rank Rank x 2 (asymp. sig.)

Overall risk

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of financing. The latter results indicate that Salam and Istisna’ are not significantly different than Murabahah and Ijarah which contradicts the findings of Arifin et al. (2008) that shown that Salam and Istisna’ are perceived as riskier than Murabahah and Ijarah (Murabahah and Ijarah constitute the largest percentage of the Islamic banks’ assets (Al-Omar and Iqbal, 2000). Their popularity in Islamic banks may be due to the fact that banks can fairly predict the returns from these two instruments. In addition, they provide banks with regular cash flows which help them to partially meet their liquidity requirements. As such, banks may view these two instruments as less risky compared to the other instruments, particularly Istisna’ and Salam. As suggested in Table V, it is also indicated that Murabahah is significantly riskier than Mudharabah. This however contradicts the initial claim that stated that Mudharabah is riskier than Murabahah financing. At the meantime, the remaining comparisons between profit-sharing contracts and mark-up based contracts are statistically insignificant. This finding suggest that profit-sharing contracts (Musharakah and Mudharabah) are perceived riskier than mark-up based contracts (Murabahah, Salam, Istisna’ and Ijarah). This finding is in contradiction with the results of Khan and Ahmed (2001) who concluded that Profit sharing contracts (Musharakah and Mudharabah) are perceived riskier than mark-up contracts (Murabahah, Salam, Istisna’ and Ijarah). 4.2 Risk management system and process The need for appropriate risk management has constrained Islamic banks to adopt various practices and techniques. Table VI presents some aspects of establishing a risk management environment. It is indicated that, 64 per cent of Islamic banks (15 institutions) have a formal risk management system in place, 56 per cent of institutions (13 Islamic banks) have a committee/section responsible for identifying, monitoring, and controlling different risks. In our sample, 18 Islamic banks (about three quarters) have internal auditors responsible of reviewing and identifying the risk management analysis systems, guidelines and risk reporting. Profitability is the ultimate test to assess the effectiveness of risk management. In this context, 83.3 per cent of institutions (19 establishments) believe that managing risk is important to the performance and success of the Islamic bank. 80 per cent of the institutions (19 Islamic banks) think that, the application of risk management techniques reduces costs and expected losses average. Economic capital is the underlying concept behind Basel II regulatory capital definitions. It reflects an institution’s actual risk profile. Calculating economic capital is a key tool for allocating capital and for assessing risk-adjusted performance. Some institutions calculate economic capital of an enterprise basis without making separate calculations for individual risk types. Larger institutions understand the economic capital associated with each of the major type of risk they face. For Islamic banks, most institutions do not calculate economic capital for traditional risk categories. Table VII shows that a mean of 2.48 of the institutions calculate economic capital for interest risk rate and a mean of 2.46 for operational risk and liquidity risk. The lower means were recorded for credit risk (a mean of 2.21) and market risk (a mean of 2.29). The low means indicate that economic capital is not widely used suggesting that Islamic banks in MENA region do not give importance to the economic capital framework. It seems that Islamic banks did not yet fully apply the review procedures suggested in Pillar 2 of the Basel II.


Table V. Paired samples test for the various types of risk

1 2 3 4 5 6 7 8 9 10 11 12

Salam-Murabahah Salam-Ijarah Istisna-Mudharabah Istisna’-Ijarah Musharakah-Salam Musharakah-Murabahah Musharakah-Istisna Musharakah-Ijarah Mudharabah-Salam Mudharabah-Murabahah Mudharabah-Istisna Mudharabah-Ijarah

2 0.03297 0.39560 0.05102 0.27619 2 0.33766 2 0.27778 2 0.34066 0.12698 2 0.08333 2 0.19286 2 0.05102 0.21088

0.91129 1.04516 0.96176 0.92182 0.82875 0.61489 0.92129 0.63867 0.92071 0.41006 0.96176 0.46427

SD 0.25275 0.28988 0.25704 0.23801 0.24988 0.14493 0.25552 0.15054 0.26579 0.09169 0.25704 0.10131

2 0.58366 2 0.23598 2 0.50428 2 0.23430 2 0.89442 2 0.58355 2 0.89739 2 0.19062 2 0.66833 2 0.38477 2 0.60632 2 0.00045

0.51772 1.02719 0.60632 0.78668 0.21910 0.02800 0.21607 0.44459 0.50166 2 0.00094 0.50428 0.42222

20.130 1.365 0.198 1.160 21.351 21.917 21.333 0.844 20.314 22.103 20.198 2.082

t

12 12 13 14 10 17 12 17 11 19 13 20

Df

86

Pair Pair Pair Pair Pair Pair Pair Pair Pair Pair Pair Pair

Mean

Paired differences 95% confidence interval of the difference SE mean Lower Upper

0.898 0.197 0.846 0.265 0.206 0.072 0.207 0.411 0.760 0.049 0.846 0.050

Sig. (two-tailed)

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4.3 Credit risk management Basel II was designed to improve the risk sensitivity of an institution’s regulatory capital measures and requires improved measurement of credit, market and operational risks in response to the experience of the global financial crisis. Regarding the implementation of Basel II, most of the institutions were using or intending to use less advanced approaches. For credit risk, 66.7 per cent of Islamic banks were using the standardized approach; while 19 per cent have chosen the foundation approach and 14.3 per cent have adopted the advanced internal rating based approach. The global financial crisis that led to massive credit losses has induced the credit risk management function to extend its focus by including both issuer and counterparty risk. For assessing underlying and issuer credit risk, the most common approach used was exposure at default (mean of 3.75), the loss given default (mean of 3.58) and probability of default (mean of 3.5). However, the principal/notional approach is less used (mean of 2.75) (Table VIII). For measuring counterparty credit exposures, it is indicated that, Islamic banks are using a number of techniques. Table IX reports that these institutions only sparsely use the principal/notional techniques (mean value of 2.54) and use more assessment of potential counterparty/exposure by simulation (mean value of 3) and the sum of potential exposure for individual transactions (mean value of 3.21). Stress testing is an important method that assess the flexibility of the institutions vis-a`-vis adverse economic and market conditions. Table X depicts that the majority of Islamic banks use stress testing for default rates by focussing on factors such as obligator/sector/geography/vintage (a mean value of 4.42). A mean of 3.46 is recorded by institutions that employ extensively the stress testing for recovery rates, for interest rate changes (a mean value of 3.88), for correlation (a mean value of 2.96) and for


Number of affirmative responses Percentage Do you have a formal risk management system in place in your institution? Is there a committee/section responsible for identifying, monitoring, and controlling different risks? Is the internal auditor responsible of reviewing and identifying the risk management analysis systems, guidelines and risk reporting?

15

62.5

13

54.2

18

75

Table VI. Establishing appropriate risk management environment

Responses (%) Risk type

Yes

Not, but currently being developed

Interest risk rate Credit risk Market risk Operational risk Liquidity risk

13 25 20.8 12.5 8.3

43.5 45.8 45.8 50 62.5

No, but plan to

No, and no plan to

Mean

26.1 12.5 16.7 16.7 4.2

17.4 16.7 16.7 20.8 25

2.48 2.21 2.29 2.46 2.46

Table VII. Economic capital calculation for risk types

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88

Table VIII. Frequency of responses for the assessing and underlying credit risk

Table IX. Frequency of responses for measuring counterparty credit exposure

Table X. Frequency of responses for the type of the stress testing used for risk factors affecting the credit portfolio

spreads by underlying name (a mean value of 2.88). However, a mean of 2.54 of institutions do not practice stress tests specially designed for risks affecting the credit portfolio. This thus imply that, Islamic banks hold a due diligence process in evaluating counterparties. Many techniques are used by banks in mitigating risk. Islamic banks continue to rely on traditional methods to mitigate credit risk. For instance, collateral (a mean of 4.32) and guarantees (a mean of 4.52). Some of the more sophisticated tools for credit risk mitigation are used by relatively few institutions: on average, 3.04 of the institutions use asset securitization vehicles and 2.4 use the credit derivatives. Other used risk mitigation methods that are on-balance sheet netting (a mean of 2.96), off-balance sheet netting (a mean of 2.92), syndication and participation (a mean of 3.36) and credit insurance programs (mean of 3.44), as reported in Table XI. Islamic banks extensively use the traditional methods as the collateral and guarantees. This finding may be explained by the compliance of the collateral with the precepts of Shari’ah because collateral or guarantees take the form of cash, tangible goods, money, treasury bills, stocks and any valuable object which are not interest-based products.

Principal/notional Probability of default Loss given default Exposure at default

No plan to use

Do not use

Plan to use

Somewhat used

Extensively used

Mean

12.5

45.8

12.5

12.5

16.7

2.75

0 0 0

25 20.8 16.7

25 29.2 29.2

25 20.8 16.7

25 29.2 37.5

3.5 3.58 3.75

1 Principal/notional Assessing potential counterparty/issuer exposure by simulation Sum of potential exposure for individual transaction

Default rates by underlying factors such as obligator/sector/rating/geography/vintage Recovery rates Interest rate changes Correlation Spreads by underlying name Do not have stress tests specially designed for risks affecting the credit portfolio

2

3

4

5

Mean

25

37.5

12.5

8.3

16.7

2.54

12.5 0

20.8 33.3

37.5 33.3

12.5 12.5

16.7 20.8

3 3.21

1

2

3

4

5

Mean

4.2 4.2 0 0 0

4.2 16.7 8.3 50 50

12.5 33.3 20.8 16.7 20.8

4.2 20.8 45.8 20.8 20.8

75 25 25 12.5 8.3

4.42 3.46 3.88 2.96 2.88

4.2

62.5

12.5

16.7

4.2

2.54

The assessment of underlying and issuer credit risk, the measure of counterparty credit exposures, the use of the stress testing and the mitigation of credit risk indicate that Islamic banks have implemented some aspects and methodologies of credit risk management. 4.4 Market risk management Consideration for the capital adequacy requirements for assessing market risk was first issued by the Basel Committee in 1996. As such, institutions have been devoting more time to adopt an advanced approach for market risk. 47.82 per cent of respondents affirm that they use the standard measurement approach while 39.13 per cent use the 1988 risk weighted assets and 13.04 per cent employ the internal model approach. The turbulence environment has led many institutions aiming to manage the market risk and to implement Basel II to challenge the long-accepted methodologies, notably VaR. The Financial Stability Forum of the Bank for International Settlements noted that: “VaR measures formed a key barometer for most firms in understanding their sensitivity to changes in market conditions” (Deloitte Touche Tohmastu, 2009). In the current survey, market VaR is not extensively used by Islamic banks. Based on the report, only 33.3 per cent of the institutions were using VaR. Table XII revealed that, in our sample, institutions use VaR in order to cover credit derivatives (a mean of 2.88). This method is used for asset backed securities (a mean of 2.65), for commodity (a mean of 2.67), for fixed income (a mean of 2.54), for equity (mean of 2.71), for catastrophe and other event driven instruments (a mean of 2.35), and for foreign exchange (a mean of 2.71). This finding suggests that Islamic banks do not use the more technically advanced risk measurement approaches compared to their conventional counterparts, due to the fact that Islamic banks are still developing and face serious challenges, also some

Collateral Guarantees On balance sheet netting Off balance sheet netting Syndication and participation (whole loan sale) Credit insurance programs Asset securitization vehicles (CBO, CLO, CDO) Credit derivatives

Fixed income Foreign exchange Equity Asset-backed securities Credit derivatives Commodity Catastrophe or other event driven instruments

1

2

3

4

5

Mean

0 0 0 0 0 0 0 12

8 4 41.7 41.7 36 24 48 56

4 4 29.2 29.2 12 20 8 20

36 28 20.8 25 32 44 36 4

52 64 8.3 4.2 20 12 8 8

4.32 4.52 2.96 2.92 3.36 3.44 3.04 2.4

1

2

3

4

5

Mean

16.7 4 8.3 8.7 12.5 4.2 8.7

37.5 40 33.3 52.2 37.5 50 60.9

20.8 28 37.5 13 12.5 20.8 21.7

25 12 20.8 17.4 25 25 4.3

0 16 0 8.7 12.5 0 4.3

2.54 2.96 2.71 2.65 2.88 2.67 2.35


Table XI. Frequency of responses to the practice of credit risk mitigation tools

Table XII. Frequency of responses for the level of usage of market risk VAR

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Islamic banks are small in size and lack of ratings or external sources of credit assessment for the clients of most Islamic banks (Arifin et al., 2008). In spite of the importance of VaR, it is not sufficient given the complexity of the market risks faced by financial institutions. One of the main reasons is that, VaR does not calculate the potential impact of considerable low frequency events. Stress tests constitute an important supplement to VaR since they take account of possible events by considering potential large moves in market prices, volatility, leverage and time needed to liquidate assets. Table XIII shows the frequency of responses for the usage of stress tests by Islamic banks. Among the participants of the survey, the stress tests is used for reporting to senior management (a mean of 4), reporting to the board of directors (a mean of 4), understanding the institution’s risk profile (a mean of 4.04), setting limits (a mean of 3.28), in response to enquiries from rating agencies and regulators (a mean of 3.96), to trigger further analysis (a mean of 3.56) and to conduct strategic planning (mean of 3.32). The slight use of VaR for measuring of the sensitivity to the market conditions and the employment of stress testing suggest that Islamic banks have implemented some aspects and methodologies of market risk management. 4.5 Operational risk management The importance of operational risk management was given a greater priority by the involvement of operational risk in the Basel II capital framework. In the past, institutions had not formally or regularly measured and managed operational risk by including it in the capital framework. Many financial institutions have implemented more rigorous operational risk management process. 47.83 per cent of Islamic banks surveyed reported following the basic indicator for calculating capital requirements for operational risk while 26.02 per cent have chosen the standardized/alternative standardized approach and 26.02 per cent have adopted the advanced measurement approach. Table XIV deals with the implementation of aspects of operational risk management and indicates that institutions use identifying risk type (a mean of 4.32), gathering relevant data (a mean of 4.24), developing methodologies to quantify risks (a mean of 4.2), standardizing documentation of process and controls (a mean of 3.96), roll-out of a formal operational risk training program (a mean of 3.76) and creating metrics for monitoring each type of operational risk (a mean of 3.56).

Table XIII. Frequency of responses for the level of usage of stress testing results

Report to senior management Report to the board of directors Understand the institution’s risk profile In response to enquiries from rating agencies and regulators Trigger further analysis Set limits Conduct strategic planning

1

2

3

4

5

Mean

4 0 0

4 4 8

16 20 4

40 48 64

36 28 2

4 4 4.04

0 0 8 8

12 24 24 24

16 16 16 20

36 40 36 24

36 20 16 24

3.96 3.56 3.28 3.32

To avoid operational risk, banks have developed different methodologies. The tools used by Islamic banks surveyed are presented in Table XV. It can be seen that the most used tools are: key risk indicator (a mean of 4.32), risk assessment techniques (a mean of 4.12) and internal loss event database (a mean of 4). The least employed tools are TQM techniques (a mean of 3.17), Six Sigma (a mean of 3.16) and external loss event analysis (a mean of 3.08). Therefore, Islamic banks consider the full range of material operational risks affecting their operations, including the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. Hence, Islamic banks have implemented some aspects and methodologies of operational risk management.


4.6 Liquidity risk management Liquidity risk comes from disharmony of all business partners or unfavourable business condition (economic downturn/crisis) leading to liquidity problem (Rifki, 2010). Thus, the need for stronger liquidity risk management has been acknowledged as never before, given the global financial crisis and the recent illiquidity in many markets. Hence, many financial institutions have accumulated large liquidity buffer. Also, regulators with many institutions have focused on liquidity risk management policies, tools and procedures. The most common responses regarding the changed in liquidity environment as indicated by institutions surveyed indicated increasing strengthening of their liquidity

Identifying risk type Gathering relevant data Developing methodologies to quantify risks Standardizing documentation of processes and controls Roll-out of a formal operational risk training program Creating metrics for monitoring each type of operational risk

Risk assessment techniques Key risk indicators Internal loss event database Scenario analysis Causal event analysis External loss event analysis Internal audit results/scores Balanced scorecard Risk mapping Six Sigma TQM techniques

1

2

3

4

5

Mean

0 4 0

4 0 0

4 12 12

48 36 56

44 48 32

4.32 4.24 4.2

0

16

4

48

32

3.96

4

4

24

48

20

3.76

4

20

8

52

16

3.56

1

2

3

4

5

Mean

0 0 12 4 0 4 4 4 4 4 4.2

4 0 0 4 16 20 20 16 8 32 33.3

8 4 4 44 56 40 28 28 20 12 8.3

60 60 44 40 20 36 44 20 44 48 50

28 36 40 8 8 0 4 32 24 4 4.2

4.12 4.32 4 3.44 3.2 3.08 3.24 3.6 3.76 3.16 3.17

Table XIV. Frequency of responses for the progress of implementing operational risk management

Table XV. Frequency of responses about the practice of operational risk management tools

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Table XVI. Frequency of responses regarding the usage of tolls in managing liquidity risk

Table XVII. Frequency of responses about procedures/ practices used to manage liquidity risk

risk management function (a mean of 4.4), enhancing liquidity stress testing (a mean of 4.08), maintaining liquidity asset portfolio (a mean of 4.04), improving liquidity management policy (a mean of 4), decreasing position limits (a mean of 3.48), integrating treasury function with risk management function (a mean of 4.36), revising contingency funding plan (CFP) (a mean of 3.92), diversifying funding sources (a mean of 4.12) and improving treasury and ALM systems (a mean of 4.36) (Table XVI). In addition to the assessment of liquidity difficulties experienced during the global financial crisis by institutions and regulators, Basel III institutes new liquidity ratios and requires all institutions to have sufficient funding and liquidity sources in order to enhance liquidity requirements. Furthermore, many institutions have to meet certain criterials to upgrade their liquidity risk management process. In this context, Islamic banks surveyed have taken a wide array of actions. As reported in Table XVII, 95.65 per cent of institutions analyse the type of depositors and withdrawing factors;

Strengthen liquidity risk management function Policy Revise CFP Diversified funding sources Decrease position limits (liquidity risk tolerance) Treasury and ALM systems Integrate treasury function with risk management function Enhance liquidity stress testing Maintain liquid asset portfolios

Offering Mudharabah time deposit to gain long-term investment funds Analysing type of deposits, tenor, etc. for financing purposes Adjusting PLS ratio to make it competitive with interest rate return Analysing type of depositors, withdrawing factor, etc. Retaining profit and allocation for risk investment reserves Preferring liquid, profitable, and highly returnable economic sectors Concentrating financing on short-term debt based financing Financing short-term projects with more funds available in short-term deposits Cooperation and communication with entrepreneurs Financing monitoring and evaluation Preferring SME which have low record of NPF

1

2

3

4

5

Mean

0 0 0 0 0 0

0 4.2 4 8 28 4

12 29.2 24 20 20 8

36 29.2 48 24 28 36

52 37.5 24 48 24 52

4.4 4 3.92 4.12 3.48 4.36

0 0 0

4 8 0

8 12 32

32 44 32

56 36 36

4.4 4.08 4.04

Number of affirmative responses

Percentage of total

15

62.21

20

86.95

15 22

65.21 95.65

19

82.6

20

86.95

14

60.87

19 17 19 11

82.6 73.91 82.6 47.82

82.6 per cent of institutions retain profits and allocate for risk investment reserves, finance short term projects with more funds available in short term deposits, and finance monitoring and evaluation; with 86.95 per cent prefer liquid, profitable, and highly returnable economic sectors; 86.95 per cent of surveyed institutions analyse the type of deposits and tenor for financing purposes. Some other procedures and practices useful to manage liquidity are less employed: cooperating and communicating with entrepreneurs (73.91 percent), offering mudharabah time deposits to gain long-term investment funds (64 per cent), adjusting PLS ratio to make it competitive with interest rate return (60 per cent), concentrating financing on short term debt based financing (65.21 percent) and preferring small and medium enterprises (SME) with low record of non-performing financing (NPF) (47.82 per cent). Islamic banks have several liquidity instruments to employ. The results as shown in Table XVIII indicated that instruments mostly used are cash reserves (78.3 per cent), funds in central banks (65.2 per cent) and funds in other Islamic banks (69.6 per cent). Tools that are used to a lesser extent are emergency liquidity facility from the central bank or the government (43.5 per cent) and Islamic money market instruments (56.5 per cent).


4.7 Transparency and market discipline BCBS (1998) defines transparency as a public disclosure of reliable and timely information that enables its users to make an accurate assessment of a bank’s financial conditions and performance in relation to business activities, risk profile and risk management practices. Transparency is a key element of an effectively supervised, impervious and sound system; since information disclosure would influence a bank’s behaviour in terms of banking performance and bank risk-taking (Ibrahim et al., 2011). According to the finding of the survey as shown in Table XIX, 78.2 per cent of institutions surveyed reported that an effective disclosure permits the market participants to have better understanding of the banks’ risk profile, 86.9 per cent of surveyed institutions believe that enhanced public disclosure allows markets discipline to work earlier and more effectively, 73.9 per cent of institutions consider that market discipline based on adequate public disclosure encourages banks to maintain sound risk management systems and practices and 86.9 per cent of establishments affirm that public disclosure can reinforce specific supervisory measures designed to encourage banks to behave prudently. The same percentage was linked to the statement that indicated that, transparency in financial reports on risks allows to more accurately assessment of a bank’s financial strength and performance. Also, 95 per cent of asked Islamic banks perceive that more risk information is disclosed in the annual report of

Cash reserves Funds in the central bank Funds in other Islamic banks Using emergency liquidity facility from central bank/government Using the Islamic money market instruments


Percentage of total

18 15 16

78.3 65.2 69.6

10 13

43.5 56.5

Table XVIII. Frequency of responses regarding the instrument used for managing liquidity risk

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Table XIX. Perceptions of the issue of market discipline and transparency in Islamic banks

Effective disclosure permits that market participants have better understanding of the banks’ risk profile Enhanced public disclosure allows market discipline to work earlier and more effectively Market discipline based on adequate public disclosure encourages banks to maintain sound risk management systems and practices Transparency in financial reports on risks allows to more accurately assess a banks’ financial strength and performance Public disclosure can reinforce specific supervisory measures designed to encourage banks to behave prudently Greater risk disclosure encourages new investments in Islamic banks The more risk information disclosed in the annual report of Islamic banks, allows market participant to monitor the banks


Percentage of total

18

78.2

20

86.9

17

73.9

20

86.9

20

86.9

19

95

16

80

Islamic banks, more market participants are allowed to monitor the banks. Furthermore, 80 per cent of respondents agree that greater risk disclosure encourages new investments in Islamic banks. 5. Discussion and conclusion The unprecedented turbulence in financial markets, the dramatic fall of assets’ prices, the reduction of liquidity in many markets and the contraction in the credit markets prompted regulators to give high priority to the development of risk-based practices for the banking industry. Currently, many institutions are reconsidering their risk management governance models. In line with this, the study aimed assessing the state of risk management tools and practices of Islamic banks located in the MENA region in this new environment. The main findings of the study are summarized as follows: . Islamic banks in MENA region are generally indifferent between the various types of risk they are facing. Nonetheless, liquidity risk is perceived as the most important one, followed by Shari’ah non-compliance risk and credit risk, while market risk is rated as the least important one. . Murabahah is perceived to be riskier than mudharabah financing, which is in contrast with the common concepts of Islamic finance, namely, al kharaj bi daman or al ghurmu bil ghunmi. . Islamic bankers in MENA region are aware of the importance and the role of an effective risk management in reducing costs and improving bank performance. . Islamic banks in MENA region have in place an effective risk strategies and effective risk management frameworks (infrastructure, process and policies). . Islamic banks continue to rely on traditional methods to mitigate credit risk such as collateral and guarantees.

. . .

.

.

Market VaR is not extensively used by Islamic banks. Islamic banks implement the work required to identify operational risk. Analysing liquidity risk management shows that Islamic banks are strengthening their liquidity risk management and employing several liquid instruments. Most institutions that participated in the study avoid advanced approaches. This may be due to the fact that using advanced approaches for calculating and handling risk is currently difficult in some of the Islamic banks operating in the MENA countries due to shortage of data. Islamic banks perceive the role of transparency and market discipline and encourage the disclosure of risk information with reference to Basel II.

These findings have significant contributions to the literature by comprehensively clarifying and critically analyzing the current state of risk management among the Islamic banks in the MENA region. As such, this would subsequently have significant implications to the practitioners, as well as to the policy makers and regulators. The findings have the potential to provide important insights on the possible areas to be strengthened for a more effective and efficient management of risk for the Islamic financial institutions in general. Furthermore, in financial institutions, risk management is not only a set of methodologies and models, but a culture of risk-taking that needs to be entrenched. Hence, further extension of this research can focus on a comparative study between Islamic and conventional banks and also insurance firms in the fast growing MENA region. The study may be conducted in another region; thereby interesting results may be expected, because risk management practices are mainly affected by specific factors such as economic conditions, competition and regulations. Further research may also consider analyzing equity investment risk and rate of return risk. Though the current study has brought about significant contributions, there are still a number of limitations that should be taken into account in the future studies. Particularly, the sample size used in this study might be relatively limited; hence, future studies could attempt to extend the study by considering a larger sample size. In addition, the future studies could be conducted for specific MENA countries in order to identify the risk management practices in each of these countries separately, this could not been achieved by the current study due to the nature and size of the sample studied. References Abdul Rahman, R., Noor, S.B. and Ismail, T.H. (2013), “Governance and risk management: empirical evidence from Malaysia and Egypt”, International Journal of Finance & Banking Studies, Vol. 2 No. 3, pp. 21-33. Al-Jarhi, M. and Iqbal, M. (2001), “Islamic banking: answers to some frequently asked questions”, Occasional Paper No. 4, Islamic Development Bank, Islamic Research and Training Institute, Jeddah. Al-Omar, F. and Iqbal, M. (2000), “Some strategic suggestions for Islamic banking in the 2lst century”, Review of Islamic Economics, No. 9, pp. 37-56. Al-Tamimi, H. (2008), “Implementing Basel II: an investigation of the UAE banks’ Basel II preparations”, Journal of Financial Regulation and Compliance, Vol. 16 No. 2, pp. 173-187.


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Al-Tamimi, H. and Al-Mazrooei, F. (2007), “Banks’ risk management: a comparison study of UAE national and foreign banks”, The Journal of Risk Finance, Vol. 8 No. 4, pp. 394-409.

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Said, A. (2013), “Risks and efficiency in the Islamic banking systems: the case of selected Islamic banks in MENA region”, International Journal of Economics and Financial Issues, Vol. 3 No. 1, pp. 66-73. Tafri, F.H., Rahman, R.A. and Omar, N. (2011), “Empirical evidence on the risk management tools practiced in Islamic and conventional banks”, Qualitative Research in Financial Markets, Vol. 3 No. 2, pp. 86-104. About the authors Rim Ben Selma Mokni is a PhD candidate in finance, at the Faculty of Management Sciences and Economics, El-Manar University Tunisia. She was an Assistant Professor at the Institute of Finance and Fiscality, University of Sousse, Tunisia. Abdelghani Echchabi is a PhD candidate in business administration, at the Faculty of Economics and Management Sciences, International Islamic University Malaysia. He is holding Bachelor degree in economics and management sciences from Hassan II University in Morocco, MA in international management from University of Caen Basse Normandie in France and MSc in finance from International Islamic University Malaysia. His areas of interest include a wide range of banking and finance areas. He is currently a Research and Teaching Assistant at the Faculty of Economics and Management Sciences, International Islamic University Malaysia, and also an Ex-banker. Dhekra Azouzi is a PhD candidate in finance, at the Faculty of Management Sciences and Economics, El-Manar University Tunisia. She is holding Bachelor degree in economics and management sciences from the Faculty of Law, Political and Economic Sciences in Tunisia, Master in finance from the Faculty of Management Sciences and Economics, El-Manar University Tunisia. Her areas of interest include a wide range of banking and finance areas: international finance, behavioural finance, Islamic finance and banking, electronic banking. She was a Teaching Assistant at the Institute of High Commercial Studies, University of Sousse, Tunisia and is a member of the International Finance Group. Professor Houssem Rachdi holds a PhD as well as an MSc and a BSc in financial and banking economics. His research interests include issues of financial development, economic growth, corporate and banking performance, bank risk taking, institutions quality, banking and financial crises, prudential and banking supervision, corporate governance. Dr Rachdi teaches in the areas of microeconomics, macroeconomics, financial engineering, corporate finance, financial accounting, cash management, management performance, management quantitative techniques, statistics and probability. He graduated many BSc and Master students and his publications appeared in many international referred journals. He is the Director of the MBA in banks and insurance and Consultant in the French Corporate Governance Association. Houssem Rachdi is the corresponding author and can be contacted at: [email protected]

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