OPERATIONAL RISK TK 6413 Islamic Risk Management Norhazlina Ibrahim Nur Aziah Che Abdul Aziz Prof. Dato’ Dr. Kamaruddin Sharif

Operational Risk Definition of Operational Risk (IFSB): IIFS shall 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. IIFS shall also incorporate possible causes of loss resulting from Sharī`ah non-compliance [1] and the failure in their fiduciary responsibilities [2].  [1]Sharī`ah non-compliance risk is the risk that arises from IIFSs’ failure to comply with the Sharī`ah rules and principles determined by the Sharī`ah Board of the IIFS or the relevant body in the jurisdiction in which the IIFS operate.  [2]Fiduciary risk is the risk that arises from IIFSs’ failure to perform in accordance with explicit and implicit standards applicable to their fiduciary responsibilities. As a result of losses in investments, IIFS may become insolvent and therefore unable to (a) meet the demands of current account holders for repayment of their funds; and (b) safeguard the interests of their IAH. IIFS may fail to act with due care when managing investments resulting in the risk of possible forgone profits to IAH

Examples of Operational Loss Events

Operational Risk Framework 4 steps in managing Operational Risk

Operational Risk Framework

Operational Risk Processes Identification of risk through Incident Data Collection (IDC). -Based on 7 event types. -Fraud case need to be reported to eFIDS BNM. Assessment of risk through Risk Self Assessment and Control Self Assessment (RCSA). -Questionnaires based assessment. -Risk Scorecard: severity and probability matrix. Quantitative assessment of risk by using Value at Risk (VaR). Mitigation of risk through Action Plan, Risk Transfer and Outsourcing. Monitoring of risk through Key Risk Indicators (KRI).

Operational Risk Dimension

Roles & Responsibilities 1 st line of defense 1 st line of defense Primary responsibility for the management of operational risk in order that accountability and ownership is as close as possible to the activity that creates the risk thereby ensuring that effective action is taken to manage them. Operational Risk Management 2 nd line of defense 2 nd line of defense Establishing an independent operational risk management and control process which covers the design, implementation and review of its operational risk measurement and methodology. Responsibilities include establishing the framework for measurement of operational risk and control. Establishing an independent operational risk management and control process which covers the design, implementation and review of its operational risk measurement and methodology. Responsibilities include establishing the framework for measurement of operational risk and control. Direct responsibility for managing specific operational risk issues pertaining to their field of expertise. Independently ensuring that the ORM process is appropriate and functioning as designed by conducting regular reviews of the ORM process and measurement. Bank-wide Support Units Audit 3rd line of defense 3rd line of defense Business Unit

Incident Data Collection

Risk Control Self Assessment

Key Risk Indicators Threshold setting is depending on the organization risk tolerance level. Threshold could have few layers.

Capital Charge 3 methods in calculating capital charge: 1) The Basic Indicator Approach (BIA) -Alpha () is standardized at 15%. 2) The Standardized Approach (TSA) -Beta factors (β) is based on specific 8 BASEL Business Lines. 3) Advanced Measurement Approaches (AMA) -Risk factors are measured according to bank’s internal Operational Risk management system using quantitative and qualitative criteria. -Determining the capital requirement is subject to the Central Bank’s approval. -To fulfill criteria set before implementing AMA.

Basic Indicator Approach Formula:

Standardized Approach Formula:

Standardized Approach 8 BASEL Business Lines:

Standardized Approach Alternative Standardized Approach (ASA) only for retail and commercial banking business lines: K RB = β RB x m x LA RB where: K RB =the capital charge for Retail Banking business line β RB =the beta for Retail Banking business line m=0.035 (replace gross income as exposure indicator) LA RB =total outstanding retail loans and advances (non-risk weighted and gross of provisions), average over the past three years

Gross Income Computation Net Interest IncomeA Comprising: All interest income (excluding interest suspended and recoveries) Less: Interest expense XXX (x) Net [1] Non-Interest Income [1]B Comprising: Net commissions / fees receivable (including outsourcing fees receivable, excluding outsourcing fees paid) Net income from trading book securities (including unrealised gains / losses from fair value changes of trading book securities) Other operating income Including intra-group income Dividend income from investment in securities Others Excluding:  Dividend income from subsidiaries and associated companies  Realised or unrealised profits / losses from sales or impairment of securities in banking book  Income from extra-ordinary or irregular item  Income from insurance recoveries XX X Total Gross Income from Islamic Banking OperationsZ Total Gross IncomeA + B + Z

Net income from financing activitiesA Net income from investment activitiesB Other income: Realised / unrealised gains / losses from sales or fair value changes of trading book securities Net commission / fees receivables Intra-group income Dividend income from investment in securities Income from non-Shariah compliant sources Others Excluding:  Dividend income from subsidiaries and associated companies  Realised or unrealised profits / losses from sales or impairment of securities in banking book  Income from extra-ordinary or irregular item  Income from insurance recoveries  Bad debt recovered C Less: Income attributable to investment account holders and other depositors D Total Gross Income (Z)A + B + C - D Gross Income Computation Islamic Banking Operation

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