Risk Management for Islamic Banks Recent Developments from Asia and the Middle East Wiley Finance Series

Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East analyzes risk management strategies in Islamic banking, presented from the perspectives of different banking institutions. Using comprehensive global case studies, the book details the risks involving various banking institutions in Indonesia, Malaysia, UAE, Bahrain, Pakistan, and Saudi Arabia, pointing out the different management strategies that arise as a result of Islamic banking practices. Readers gain insight into risk management as a comprehensive system, and a process of interlinked continuous cycles that integrate into every business activity within Islamic banks.

The unique processes inherent in Islamic banking bring about complex risks not experienced by traditional banks. From Shariah compliance, to equity participation contracts, to complicated sale contracts, Islamic banks face unique market risks. Risk Management for Islamic Banks covers the creation of an appropriate risk management environment, as well as a stage-based implementation strategy that includes risk identification, measurement, mitigation, monitoring, controlling, and reporting. The book begins with a discussion of the philosophy of risk management, then delves deeper into the issue with topics like:

• Risk management as an integrated system
• The history, framework, and process of risk management in Islamic banking
• Financing, operational, investment, and market risk
• Shariah compliance and associated risk

The book also discusses the future potential and challenges of Islamic banking, and outlines the risk management pathway. As an examination of the wisdom, knowledge, and ideal practice of Islamic banking, Risk Management for Islamic Banks contains valuable insights for those active in the Islamic market.

Preface xv

Acknowledgments xxi

About the Authors xxiii

List of Acronyms xxv

PART ONE Introduction

CHAPTER 1 Principles of the Islamic Financial System 3

Islamic Financial Contracts: The li-tabarru’ Contract versus li-tijari Contract 3

Principles of Islamic Finance 5

Interest-Based Return versus Profit–Loss Sharing 6

CHAPTER 2 The Islamic Bank and Risk Management 9

Differences between an Islamic Bank and a Conventional Bank 10

History of the Islamic Bank 11

Global Islamic Banking Entities 12

Risk as an Integral Part of Islamic Bank 16

Stages in Risk Management 20

Risk and Return Trade-Off 27

Various Approaches on Risk Identification 28

The Importance of Risk Management for an Islamic Bank 28

PART TWO Risk Management Framework in Islamic Banking

CHAPTER 3 History of Risk Management in Islamic Banking 33

Basel I and Its History 34

Basel II and Its History 36

Basel III and Its History 40

The AAOIFI and Its Role 43

The IFSB and Its Role 44

CHAPTER 4 The Risk Management Process in Islamic Banking 47

Risk Management Model in Islamic Banks 47

Risk Identification Process in Islamic Banking 56

Risk Matrix 57

Risk Mitigation Process 61

Risk Review Process 62

Infrastructure and Facilities 62

Calculation of Minimum Capital Requirements 66

CHAPTER 5 Financial Reporting and Analysis in Islamic Banking 72

The Importance of Financial Statements in Risk Analysis 72

Scope of Financial Statement in Islamic Banks 74

Basic Contracts and Instruments in the Islamic Bank 78

Structure of the Balance Sheet 80

Analysis of Income Statement 87

Persistence Analysis 88

Tools of Financial Statement Analysis 89

Core Business Activity in Islamic Banks 92

Off-Balance Sheet Activity in Islamic Banks 101

PART THREE Risk Management in Islamic Banking

CHAPTER 6 Financing Risk in Islamic Banking 107

Urgency of Financing Risk Management in Islamic Banking 107

Characteristics of Islamic Financing Contracts 108

Financing Risk: Definitions and Its Scope 110

Role of Rahn and Kafalah 112

Defining Determinant Factors of Financing Risk 114

Urgency of the Independent Rating Agency 128

Rating and Financing Risk Provisions 130

Risk-Based Financing Limit 133

Concentration Risk in Financing Portfolio 133

Financing Portfolio Management 135

Measuring Financing Risk in the Islamic Bank 139

CHAPTER 7 Operational Risk in Islamic Banking 144

Urgency of Risk Awareness 144

Operational Risk Coverage in Islamic Banks 145

Identification of Operational Risk Factors 149

Operational Risk in Islamic Financial Contracts 155

Measurement of Islamic Operational Risk 160

Developing an Operational Risk Management System 166

CHAPTER 8 Syari’ah Compliance Risk 168

Basic Principles of Islamic Economics and Financial System 169

Syari’ah as Principle and Spirit in Business 170

Various Prohibitions in Mu’amalah 172

Why Should Islamic Banking Comply with Islamic Principles? 175

Integrating Syari’ah Compliance in the Islamic Bank 176

Evolution of Syari’ah Governance in Islamic Financial System 177

Syari’ah Advisory Board and Syari’ah Compliance Audit as a Framework 179

Identification Process of Syari’ah Compliance Risk 183

Risk Management and Mitigation of Syari’ah Compliance Risk 187

Models of Syari’ah Governance in Several Countries 188

CHAPTER 9 Strategic Risk 194

Definition and Scope of Strategic Risk in Islamic Banking 195

Determinants of Strategic Risk and Its Mitigation 196

Issues Related to Strategic Risk 204

CHAPTER 10 Investment Risk in Islamic Banking 209

Syirkah as a Distinct Trait of Islamic Banks 209

Basic Concept of Investment Risk 210

Forms of Risk and Their Mitigation 216

Regulations on Profit Distribution Management 230

CHAPTER 11 Market Risk in Islamic Banking 232

Urgency of Market Risk 233

Scope of Market Risk in Islamic Banks 234

Identification of Market Risk Profile 239

Market Risk Measurement in Islamic Banks 244

Market Risk Mitigations in Islamic Banking 253

Implementation of Market Risk Mitigation 256

CHAPTER 12 Liquidity Risk in Islamic Banking 264

Urgency of Liquidity Risk 264

Credit Multiplier, Financial Stability and Liquidity Crises 265

Definition and Coverage of Liquidity Risk 267

Islamic Bank’s Assets and Liabilities 271

Liquidity Risk Management in Islamic Banks 272

PART FOUR Future Prospects and Challenges in Islamic Banking

CHAPTER 13 Development of the Islamic Financial Market 285

Islamic Capital Market 286

Derivative Islamic Market 292

Regulation and Supervisory in Islamic Financial Market 294

Institutional-Based Development Framework 295

Stability in Islamic Financial System: Lesson from Global Financial Risk 296

CHAPTER 14 Development of a Pricing Model in Islamic Banking 299

Fundamentals in Islamic Pricing Model 299

Time Value of Money in Pricing Model 302

Current Islamic Pricing Model 305

Urgency of Pricing Mechanism in Islamic Banks 314

CHAPTER 15 Pathways of Risk Management in Islamic Banks 315

Islamic Banks as Real Implementation of Risk Management 315

Challenges of Islamic Banking in the World 317

Blueprint for Islamic Banking Regulation 319

Prospects and Challenges of Islamic Banking Development 323

Strategic Issues in the Implementation of Islamic Risk Management 324

CHAPTER 16 Future Agenda 328

Landscape of Integrated Islamic Risk Management 329

Synergy and Integration among Islamic Financial Institutions 330

Competency and Competitiveness of Islamic Banking 331

Regulatory Agenda in the Future 333

Anticipating the Potential Systemic Risks 335

PART FIVE Conclusion

CHAPTER 17 Summary and Conclusion 345

Glossary 350

Bibliography 359

Index 383

IMAM WAHYUDI is a lecturer in the Faculty of Economics and Business at University of Indonesia (FEB-UI) and a senior researcher at the Centre of Islamic Economics and Business.

FENNY ROSMANITA is a lecturer at FEB-UI and a researcher at its Centre of Islamic Economics and Business.

MUHAMMAD BUDI PRASETYO is a lecturer and junior researcher in the Department of Management at FEB-UI.

NIKEN IWANI SURYA PUTRI is a lecturer at FEB-UI and a junior researcher at its Centre of Islamic Economics and Business.