Challenges and Opportunities Risk Issues with Islamic Banking 1/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes Risk issues with Islamic Banking Warren Edwardes, ceo, Delphi Risk Management 3rd International Islamic Banking, Finance & Insurance Conference Ottawa Congress Centre, Ottawa, Canada May 17 th / 18 th 2007 Delphi’s Islamic banking articles (and this powerpoint) : dc3.co.uk/ibnews

Challenges and Opportunities Risk Issues with Islamic Banking 2/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes financial risk some actions can protect the same actions can destroy risk – a film

Challenges and Opportunities Risk Issues with Islamic Banking 3/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes Islamic Banking Risk Does Islamic banking risk differ from Conventional banking risk? Not different - just a very special case –Trade credit ? –Asset backed Secured or unsecured ? –Debt or equity ? –Leasing / Ijara –Repos / Murabaha ? –Fund management ? Islamic Banking is about who bears risk

Challenges and Opportunities Risk Issues with Islamic Banking 4/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes Regulation Basel II does apply The Islamic Financial Services Board (IFSB) – The Accounting & Auditing Organization for Islamic Financial Institutions, (AAOIFI) – Is it banking or financing? A check-list of 50 banking risk types

Challenges and Opportunities Risk Issues with Islamic Banking 5/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Acquisition Risk –Different cultures between banks “consolidating” Careless Error Risk –Human error should be forgiven. But this is not covered by law Competitive Risk –LIBOR determines competitors returns Commodity Risk –If you take delivery can the commodity price be managed?

Challenges and Opportunities Risk Issues with Islamic Banking 6/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Communication Risk –Define terms clearly –Deposit or managed funds? Country Risk –much of Islamic banking is carried out in emerging markets. Riskier? UAE is stable in the eyes of Mid East investors Credit Risk –Not loans. Not IOUs. So equity not loan risk Cultural Risk –Difference between Gulf and Malaysia - narrowing

Challenges and Opportunities Risk Issues with Islamic Banking 7/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types – 9-12 Currency Transaction Risk –use of derivatives generally not allowed – changing –Cannot hedge exchange rate for purchases Currency Translation Risk –Balance sheet value of dollar assets or liabilities fluctuate Currency Economic Risk –Again no hedging permitted Customer Satisfaction Risk –If a bank pays no dividends customers will get angry –Moral hazard

Challenges and Opportunities Risk Issues with Islamic Banking 8/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Disaster Recovery Risk –If a terrorist or earthquake strikes can you cope? Economic Activity Risk –Applies when overheads are fixed. Outsourcing a solution Energy Price Risk –Many Islamic countries’ economies are linked to the oil price Environment Risk –Are environment unfriendly policies haram?

Challenges and Opportunities Risk Issues with Islamic Banking 9/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Equity Market Risk –Islamic banking is ideally profit and loss sharing. This is venture capital or equity investment Fraud (banker) Risk –Gharar. Transparency is required. Avoid the risk of misinterpretation and mis-selling Fraud (customer) Risk –If an investor loses money will he seek redress? Of course if he wins he will not Fraud (staff) Risk –BCCI was not an Islamic bank

Challenges and Opportunities Risk Issues with Islamic Banking 10/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Image / PR Risk –Something hallal could be deemed haram. Information Risk –Was lack of transparency in accounts but AAOIFI is changing this Inflation Risk –Securitised asset rises in value but not the repayment amount which being a cash amount depreciates. Time value of money? Interest Rate Risk –This is not a closed economy. If interest rates rise sharply deposits will flow out. LIBOR linking

Challenges and Opportunities Risk Issues with Islamic Banking 11/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Interaction Risk –Correlation risk. What happened in New York and Baghdad impacts on KL. Language Risk –Arabic, English, Malay, Indonesian, Urdu? Same word can have different meanings. Legal Risk –UK, Malaysian,.. –Is the bank / customer permitted to carry out such business?. Ultra Vires issue

Challenges and Opportunities Risk Issues with Islamic Banking 12/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Liquidity Risk –Major problem for Islamic banking is the absence of a developed Islamic money market. –about managing confidence and the liability side –About managing diversification. Morbidity Risk –No different from conventional banking. What happens if there is an outbreak of dengue fever or Anthrax? Mortality Risk –Do you have offices in a tall building? –Would you survive major loss through fire?

Challenges and Opportunities Risk Issues with Islamic Banking 13/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Operational Risk –Are strong procedural systems in place? Really everything other than market risks Performance Measurement Risk –Most measures of performance are crude and slavish adherence to rules can lead to poor real performance Political Risk –Seizure of assets post Sep 11 Competence / Understanding –Are the latest products really understood by the banks’ senior management? By the customers?

Challenges and Opportunities Risk Issues with Islamic Banking 14/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Concentration of assets Risk –A problem for Islamic funds. No tobacco, banking and alcohol stocks can lead to heavy weighting in property and technology Concentration of liabilities Risk –Are there enough investors? Concentration of business type Risk –Can a specialist Islamic bank compete with a full service bank? Convertibility Risk –Deliverability risk under exchange controls

Challenges and Opportunities Risk Issues with Islamic Banking 15/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Property (Real Estate) Risk –Would asset backing be sufficient in times of a property crash? Rating Agency Risk –A downgrading or even credit watch can impact on liquidity and the entire business. Investment grade bonds do not default. They become junk and then default. Regulatory Risk –A firm operating globally will face different rules. But less so now with Basel II / AAOFI / IFSB Religious Risk –A Hallal product may be deemed Haram. Zero coupon bonds were once Hallal. No Central Shariah authority – ex Malaysia

Challenges and Opportunities Risk Issues with Islamic Banking 16/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types Resignation Risk –Over dependence on one person’s skills and market contacts? Settlement Risk –If there is no escrow account there is settlement risk on Murabaha and BBA Systemic Risk –Financial instability is contagious. Financial systems are closely inter-linked Tax Risk –Do the sale and repurchase transactions face sales tax? Income tax or capital gains tax treatment?

Challenges and Opportunities Risk Issues with Islamic Banking 17/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types – Technological Risk –Are your fax confirmations going to your customer or a competitor? Transport Risk –traffic jams may have led to cancelled meetings which may never be rearranged Weather Risk –Could you hedge against the weather? –Weather derivatives are being traded. Haram? Weather Takaful?

Challenges and Opportunities Risk Issues with Islamic Banking 18/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes banking risk types – 50 Zero Risk It’s impossible to take an unnecessary risk. because you only find out whether a risk was unnecessary after you’ve taken it Giovanni Agnelli, President FIAT

Challenges and Opportunities Risk Issues with Islamic Banking 19/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes Conclusion: Islamic banking risk issues Liquidity – under developed money market Interest rate Risk Commodity Risk Communication Risk Equity risk – fund management or banking? Operational risk Religious – Hallal or Haram? Language Risk - English, Arabic, Malay or Urdu

Challenges and Opportunities Risk Issues with Islamic Banking 20/27 3rd International Islamic Banking, Finance & Insurance Conference, Ottawa May 17 & 18, 2007 Warren Edwardes My Book