Risky Business

Discussions brewing among Islamic bankers about the direction Islamic finance should take could have implications in several areas, not least the risks their banks will face and the risk management measures they have in place.

Having passed its early stages of growth, industry practitioners say the Islamic finance industry has reached a fork in the road and a choice must be made, whether it continues to develop as an Islamic version of the conventional finance market or it diverges to redefine itself and stay true to its Islamic roots. "The industry is at a point where it is maturing and the issue is 'Where do we go next?'" said John HH Lee, a partner at KPMG.

For banks, the discussion is a case of whether to stick with their existing Shariah-compliant approach or take on a new Shariah-based approach with all its attendant risks. "A lot of what has happened in Islamic finance is a copy of the conventional finance system and making it Shariah-compliant," said Daud Abdullah Vicary, global Islamic finance leader at Deloitte.

Since the Islamic finance industry's early beginnings, in order to gain acceptance among investors familiar with conventional banking products, Islamic banks have found it more convenient and easier to modify conventional products to become Shariah-compliant than structure completely new products based on the Shariah. Shariah-compliant products are essentially conventional products that have been tweaked so as not to violate Shariah principles, whereas Shariah-based products are developed from Islamic teachings and as a result, need to be innovated as they have no precedent in the conventional system.

"One school of thought is that we continue mirroring the conventional system and replicating products as there are still a lot of Muslim consumers not using them," said Lee. "The other is to go back to what Islamic finance is really about – equity, fairness, profit-sharing."

Islamic finance is founded on the principles of being in sync with the real economy, sharing of risk and wealth, avoidance of interest charges and gambling, and focusing on the wellbeing of mankind. In contrast, the conventional system is not ethically-based and, as the recent financial crisis highlighted, has become disengaged from the real economy.

With the industry having come as far as it has, there is uncertainty among bankers as to whether to embrace change or stick to the path of least resistance. Industry participants such as KPMG's Lee believe the strategy of diverging from the conventional finance system is the right one to take despite the difficulties and discomfort a change will bring.

"It is a more interesting option because it creates more innovation which implies it is a true alternative rather than a mirror of the main financial system," said Lee, who sits on the liquidity risk management committee of the Islamic Financial Services Board.

However, redefining themselves as authentic Islamic banks is not without risk. In diverging from the conventional route, the banks will themselves need to evolve, as well as create and innovate new products that will in turn mean new risks, and the need to assess and measure them and put in place new measures to mitigate them.

"Depending on the products (banks) choose and the way in which they are structured, the risk would change," said Lee. "If the risk changes, then the risk management would need to evolve. Because the product direction is different from the conventional, risk management skills and tools would need to be different."

As part of the discussion on the direction for the industry, debate is ensuing as to whether Islamic banks should shift away from debt-based financing in favour of more equity-based products and structures such as musharakah and mudarabah, which are widely acknowledged to reflect more closely the spirit and teachings of the Shariah because they involve the sharing of profit and of risk between a customer and a bank.

Debt-based financing, associated with the ills of the conventional finance system, is highly popular in Malaysia and the Middle East where it accounts for more than 70% of all Islamic transactions. And while these transactions can pose a credit risk, this a known risk to banks and one they can safeguard against. On the other hand, equity-based financing accounts for only 2% of Islamic transactions and poses potential threats that could arise from banks' relative unfamiliarity with it and the risks it carries.

Such a strategic change in direction also poses a reputational risk as clients may feel betrayed and disenchanted with their bank and previous Shariah-compliant products sold to them, giving rise to concerns about how Islamic they actually are. "The challenge is communicating this to people, who will ask 'How come the change?' and 'Why didn't you pick this up when you started?'" said Deloitte's Daud.

Educating consumers about a change in approach as part of the natural development of any young industry is vital to retaining customer trust and loyalty as is creating awareness about what Shariah-based banking means. "From a practical business end, if you were an Islamic bank and people trust you, you cannot betray that trust and say everything you sold was not true," said Daud. "But, if (banks) deal with it in an honest way – and debate is beginning to occur – communicating it clearly and recognising it is an issue, they will get the support of the public at large that this is part of development," he added.

Not going down the untrodden path of taking the Shariah-based approach could, at the extreme, challenge the very existence of Islamic banks, industry participants pointed out. By continuing to mimic the conventional financial system, Islamic banks run the potential risk of becoming irrelevant. "Banks need to be moving forward and not standing still and denying anything needs to change," Daud said.

Given the complicated nature of the issue, industry participants are aware that it is not likely to be resolved soon. But they are heartened that discussions have been taking place since last year and hope banks begin to address the issue soon before it turns into an urgent strategic risk.

In the meantime, liquidity, credit and Shariah risk remain the more pressing risks Islamic banks face. Given their similarities with conventional banks, Islamic banks share many risks in common with conventional banks – liquidity risk, operational risk, credit risk and market risk – and risk mitigation strategies and measures have been co-opted from conventional banks and adapted to the specificities of various Shariah-compliant products.

In the case of liquidity risk, Islamic banks are forced to keep a substantial amount of their assets in cash or cash equivalents at the expense of profitability, owing to a lack of tradable money market instruments. "There are very few Shariah-compliant liquidity management instruments because of lack of sukuk and very few equivalents of conventional, riba-based repo," explained Anouar Hassoune, vice-president and senior credit officer at Moody's Investor Services.

Despite the shortage of short-term Islamic money market solutions, Hassoune added that liquidity can be managed as part of a "two-pronged strategy" that involves widening the pool of available sukuk, developing local, regional and international Shariah-compliant bond markets and ensuring that central banks have, as part of their liquidity management arsenal, an Islamic repurchase agreement scheme in place.

"One without the other would have limited benefits as you need both the mechanism and the underlying assets in order to secure proper liquidity management at the macro level,'' said Hassoune.

Credit risk – or the risk that a counter-party in a transaction may default on payment – is another threat faced by Islamic banks which the recent financial crisis has highlighted. The crisis resulted in a number of sukuk defaults, which have spawned issues including the legal enforceability of documentation, sukuk holders' rights, the role and efficacy of Shariah governance and due diligence for Shariah compliance. "In terms of the perception of the market, what I would say is that legal enforceability and the potential of defaults of sukuk clearly are an issue that needs to be addressed," said Deloitte's Daud.

Although the law has not been tested in relation to the enforceability of documentation, industry participants suggest that it is an area that regulators and industry bodies should tackle in order to encourage standardisation of documentation. "If people are concerned that the documents are not enforceable then this is a major problem," said Razi Fakih, deputy CEO of HSBC Amanah.

"The reality is that Islamic financing documentation is drafted for compliance with applicable local laws and in compliance with Shariah as approved by the Shariah committees or boards. So, in the event of default, it is unlikely that the Islamic finance documentation would be any worse than conventional financing documentation."

Deloitte's Daud added that because the issue "is all about perception", what is needed is "education, not risk management."

In the area of Shariah risk, risk management techniques and processes are still evolving, industry participants noted. "Shariah risk – or the risk of financial loss, regulatory sanction or reputational damage to an Islamic financial institution as a result of failure to comply with guidelines issued by relevant Shariah committees in respect of the development, execution, delivery and marketing of products and services – is a risk specific to Islamic banks and is an area that has not really been focused on despite the potential of leading to significant reputational risk," said HSBC Amanah's Fakih.

Islamic banks take Shariah risk into account by setting capital against it, but that is not enough to deal with all the risks it entails. Banks would do better to ensure that front office and operations personnel are appropriately trained and that new products are subject to a robust due diligence process that can be supplemented by spot checks, audits and Shariah internal control reviews, Fakih added.

Overall, the risk management practices of Islamic banks are adequate and even "comparable to those of peer conventional banks," noted Moody's Hassoune. "Banks have allocated resources to defining, identifying, measuring and either mitigating or accepting risks across business lines, while in terms of compliance, audit and controls, they have considerably strengthened their policies, procedures and practices over the past decade," he added.

This article first appeared in the June 2010 issue of Islamic Finance Asia. For more details, please visit