Presentation on theme: "Prof. Saiful Azhar Rosly, Banking Department INCEIF Pre-Examination Session Class Review IB2002 Risk Management for IFIs."— Presentation transcript:
Prof. Saiful Azhar Rosly, Banking Department INCEIF Pre-Examination Session Class Review IB2002 Risk Management for IFIs
Risk Management Risk management is a continuing process of corporate risk reduction Risk management is about how firm actively select the type and level of risk that is appropriate for them to assume. Risk management and risk taking are two sides of the same coin.
Business risk Potential loss in the world of business due to uncertainty about: 1. Demand for products 2. The price that can be charged for those products 3. The cost of producing and delivery the products
Risk is potential loss Risk itself is not an evil thing Avoiding risk with zero profit is allowed – Wadiah Yad Dhamanah deposit Avoiding risk with positive profit is not allowed – interest from loans. Avoiding risk is an evil action if it injures the counterparty – interest from loans
Risk Management in Islamic Banking Fundamental principle in Islamic business : a. no reward without risk – al-ghorm bil ghonm b. With profit comes liability – al-kharaj bil daman. Risk taking behaviour – as the above – risk > 0, profit > 0 permissible Risk avoiding behaviour – risk =0, profit >0 - not permissible
2 dimensions of Islamic bank risk management Profitability (Making profit with risk) Banking book Credit risk Market risk, operational risk Liquidity risk RoR, DCR, Shariah risk Trading book Market risk Operational risk Legal risk Financial stability Basel II IFSB 1. Capital Adequacy 2. Supervision 3. Market discipline
Profitability vs Financial Stability Banks as profit-maximizing firms cannot be left alone without proper regulations by authorities. Banks may take excessive risks and overlooked safety of depositors fund, eroding capital and thus jeopardizing public confidence. Thus in making profit, banks may introduce financial instabilities. The purpose of regulation is to instill financial stability by controlling banks behaviour.
Loss due Risk exposures Reduce Earnings Reduce Capital Bank Failure Financial Instability
Unexpected Loss Capital Depletion Insolvent Banks Credit Crunch Recession
5 Basic Shariah Principles in Financial Transactions #2Application of Al-Bay#3Avoidance of Gharar #4 Prohibition of Gambling(Maisir) #5Prohibition of Impure Commodities #1 Prohibition of Riba
Islamic Bank Risk Management Process Credit Scoring PD, LGPD Business Plans Cash Flows Appraisal & Due Diligence Pricing Risk premium Security Take Position Effects of Exposure due to Systematic and Unsystematic risks Risk Mitigation Monitoring
Risk Management Take Position: Risk-Taking Impact on Firm OPTIONS OF RISK MANAGEMENT Risk Avoidance Risk Avoidance Risk Prevention/Reduction/ Mitigation Risk Prevention/Reduction/ Mitigation Risk Transfer Insurance Derivatives Risk Transfer Insurance Derivatives
Failures of Risk Management Long-Term Capital Management (LTCM) Enron WorldCom Global Crossing Parmalat Lehman Morgan Stanley AIG Bears & Stearn Northernrock Washington Mutual More coming soon… subprime world crisis
Islamic Banks Average Balance Sheet AssetLiability CashWadiah Dhamanah Current Account BBA Home FinancingWadiah Dhamanah Savings Account AITAB Car FinancingRestricted Mudarabah Account Bay al-Inah Personal Financing Enterprise Financing Unrestricted Mudarabah Account Government Islamic SecuritiesCommodity Murabahah Negotiable Islamic Certificate of Deposits Sukuk Fixed AssetsShareholders Capital
Income Statement Reward comes with Risk Islamic Banking Profit and Loss Revenues Cost of Funds $500m $200m Gross Profit$300m Overheads Provisions for NPF Profit Equalization Reserve $80m $10m Profit Before Tax and Zakat$200m Tax and Zakat$60m Net Profit$140m
Risk Banking Book Eg. BBA Trading Book Eg. Sukuk
Risks in BBA Financing Credit Risk Low credit scoring for Islamic customers, higher probability of default (PD) Credit Risk Low credit scoring for Islamic customers, higher probability of default (PD) Market Risk Negative Gap can mean losses as Interest rate increases Market Risk Negative Gap can mean losses as Interest rate increases Shariah Risk Recent Court Judgement on murabaha/BBA as non bona fide sale Shariah Risk Recent Court Judgement on murabaha/BBA as non bona fide sale Operational Risk Conventional solution/system not able to accomodate Islamic accounting principles leading to overcharging and undercharging customers. Operational Risk Conventional solution/system not able to accomodate Islamic accounting principles leading to overcharging and undercharging customers. High NPF and Write- Offs Capital Depletion High NPF and Write- Offs Capital Depletion Earning at risk (EAR) Capital at risk (EAR) Earning at risk (EAR) Capital at risk (EAR) Litigation Costs Erosion of earnings Litigation Costs Erosion of earnings Increase Overheads Litigation costs Increase Overheads Litigation costs
Risk-taking Once the bank accepts the risk, it must manage it. What are the risks faced by an Islamic bank? The Islamic banks shareholders face the following risks: 1. Credit risk 2. Market risk 3. Liquidity risk 4. Operational risk 5. Commercial displacement risk 6. Rate of return risk 7. Shariah risk Losses arising from risky financing facilities will adversely affect deposits and shareholders capital. The objective of banking regulation (Basel II) is to protect deposits. When losses wiped out banks capital, the bank becomes insolvent.
Risk Management in Islamic Banking Concept of risk in Islam Risk in trading and commercial transactions (al-bay) Risk in loans Types of risk Systematic, pure and speculative risk Unsystematic Islamic Banking business Operates under Basel II Basel II – to protect depositors fund Capital adequacy requirement Risk management – Before bank approves financing facilities, it: Identify risk Measure risk Pricing Risk mitigation collateral risk transfers via derivatives
Islamic Banking Balance Sheet Asset Risk WeightLiability Murabahah $6000m 1.00Wadiah dhamanah $2000m Ijarah $2000m 1.50 Mudarabah $1000m 2.00Mudarabah investment deposits $8000m Musharakah $1000m 2.50 Others $500m 0.5 Capital ? CAR = 10% Capital ratio = Eligible Capital / Risk-Weights Assets (RWA) = $?m/RWA Eligible Capital = Capital ratio x RWA = 0.1 / (6000 x 1) + (2000 x 1.5) + (1000 x 2.0) + ($1000 x 2.5) + ($500 x 0.5) =______? Highly risky assets carry high conversion factor (Risk Weight) Islamic bank must carry more capital in order to conduct risky business.
Risk / Potential losses Murabaha : sale with installment payments Credit risk Shariah risk Ijarah: financial leasing – leasing ending with sale Credit risk Market risk Shariah risk Partnership: profit-sharing Market risk Operational risk
Islamic Banking Profit and Loss Revenues Cost of Funds $500m $200m Gross Profit$300m Overheads Provisions for NPF Profit Equalization Reserve $80m $10m $5m Profit Before Tax and Zakat$200m Tax and Zakat$60m Net Profit$140m
Credit risk Credit risk is the risk that a change in the credit quality of a counterparty will affect the value of a security or portfolio. When counterparty defaults, the bank loses either all of the market value of the position or, the part of the value that it cannot recover. a. Expected loss (LGD loss given default) – covered by provisions b. Unexpected loss – covered by capital
Islamic Banks that thrived on Credit Financing Loss due to Credit risk is inevitable
Basel II and Credit Risk Expected Loss (Covered by banks provisions) Unexpected Loss (Covered by capital) Total Loss
Loss due Credit Risk Rising Non- Performing Financing Reduce Earnings Capital Depletion Bank Failure Financial Instability
Adverse selection and moral hazard Moral hazard exists because borrowers may have incentive to engage in activities that are undesirable from lenders point of view In such situations, it is more likely that the lender will be subject to the hazard of default Banks have to overcome the adverse selection and moral hazard problem that make loan defaults more likely. Credit Risk Management
This is done by Screening Monitoring & enforcing restrictive covenants Establishment of long term customer relationships Loan commitment Specialized lending Collateral and compensating balance requirements Credit rationing Credit Risk Management
Total Loss Expected Loss Largely due to unsystematic risk Unexpected Loss Largely due to systematic risk
Credit Risk in BBA The risk of the facility is characterized by: 1. The external and /or internal rating attributed to each obligor, usually mapped to probability of default (PD). 2. The loss rate given default (LRGD) and EAGD of the facilities. LRGD is the loss rate when the borrower defaults. 3. Exposure at given default (EAGD) : notional value of a loan, or exposure for loan commitment. Amount of credit outstanding at the time of default. The expected loss (EL) for each credit facility: EL = PD x EAGD x LRGD
Example: Expected Loss Zahidi Bank hold a $500 million BBA portfolio with 15 years tenor. PD of the portfolio = 10% BBA defaulted after 5 years Exposure at given default (EAGD) = $400 Collateral $300m Loss rate given default = (EAGD – collateral)/$500m = ($400m - $300m)/$500m = ($100/$500) x 100% = 20% EL= PD x EAGD x LRGD EL = 0.1 x $400m x 0.2 = $8 million Bank will put aside $8 million for NPF provisioning.
Origination PD = 10% Default Maturity EAGD = $400m BBA PORTFOLIO = $500m EXPECTED LOSS = PD x EAGD x LRGD
Expected Loss is covered by Banks Provisioning General and Specific Provisions Expected Loss (EL) Probability of Default (PD) Loss Rate Given Default (LRGD) Exposure at Given Default (EAGD)
Credit risk inn BBA Expected loss (EL) is the basis for the calculation of the banks allowance for BBA losses, which should be sufficient to absorb both specific and general credit related losses. EL can be viewed as cost of doing business. That is, on average, the bank will incur a credit loss amounting to EL. However ACTUAL credit losses may be higher or lower than EL. The variation for credit losses beyond EL is called unexpected loss (UL). UL is the basis for the calculation of economic and regulatory capital.
Assessing credit exposure Compute EL Compute UL Determine the volatility of expected loss of a BBA to the whole portfolio. Calculate the probability distribution of credit loss for the portfolio and asses the capital required to absorb the unexpected losses.
How does an Islamic bank pass on the cost of non- performing financing provisions to the customers? Pricing, Credit risk and Expected Loss
Pricing of Debt instrument. Profit rate = Cost of deposits + cost of overheads + risk premium Banking Products Cost of Deposits Overheads Statutory margins Risk- Premiums
Banks contractual loan rate is equal to the: a. cost of deposits (r d ), b. operating costs (c), c. Statutory profit margin (p) and d. a risk premium. If we take away the risk premium, we get the targeted interest- rate (r t ), which is also known as the prime or base-lending rate (BLR). The BLR is the interest rate charged to banks best customers consisting of the interest rate on deposits (r d ) operating cost (c) and a profit margin (p).
Based on the above r t = r d + c + p. Lets say that bank pays depositors 7% and incurred 1% in operating cost and a 2% profit margin. The targeted interest rate is therefore 10%.
Now the bank receives a $180,000 BBA application from Salim. After full assessment of his credit ratings, the bank felt that Salim has a 20% default risk (p d = 0.2). This also implies that the probability of Salim making full payment is 80% (p f ). Given this information, the question now is how much should the bank charge Salim for the $180,000 BBA? Or what is the contractual profit rate (r c )?
The contractual profit interest rate is the rate set in the BBA contract in arriving at the selling price (SP). Given that Salim is a risky customer, the bank may not want to charge him the prime rate. The prime rate is the rate the bank charges to its best customer. Certainly now, the contractual profit rate is expected to be higher than the prime rate or BFR.
To obtain the contractual profit rate, the bank must first determine how much profits it desires to make from the BBA. Meaning that the expected rate of return (r e ) must be computed to find (r c ). Since the banks targeted rate of return (r t ) is equal to the BFR, it also means that expected rate of return (re) must be equal to the targeted rate of return (r t ). r t = r e
Now given Salims 20% probability of default, which is assumed to cause the bank a 10% loss (r d ), [also known as loss rate given default LRGD in a BBA portfolio] the expected rate of return (r c ) and contractual profit rate are given below:
Computing the Contractual profit rate (r c ) on a Risky BBA r e = (p f x r c ) + (p d x r d ) r e = (0.8 x r c ) + (0.2 x -0.1) r t = r d + c + p Since r t = 10% or 0.1 = 0.8r c - 0.02 r c = (0.1 + 0.02)/0.8 = 0.15 or 15%; r c r t
We can see in the above illustration that the pricing of BBA has included the credit risk factor. It has also added earlier the time- value of money factor. Profit rate = cost of GIA deposit (TVM) + OVH + credit risk the contractual profit rate (r c = 15%) is higher that the targeted rate of return (r t = 10%). This is simply because Salim is a risky customer thus was charged 5% higher than the banks best customer(s) who by definition have no credit or default risk at all. In other words, for risky borrowers, the contractual profit rate is set above the targeted rate. Likewise, the lower the default risk, the lower is the contractual profit rate relative to the targeted rate. Why is this allowed BBA and disallowed in loans?
Credit Risk Premium and EL Based on the calculated contracted rate of return (Rc), it is found that the bank charges an extra 5% based on the credit worthiness of customer. This 5% risk premium is used by the bank to cover the Expected Loss or the expenses on BBA loss provisioning.
Islamic Banking Profit and Loss Revenues Cost of Funds $500m (Rc x F) $200m (Rd x D) Gross Profit$300m Overheads Provisions for NPF Profit Equalization Reserve $80m $10m Profit Before Tax and Zakat$200m Tax and Zakat$60m Net Profit$140m Rc = cost of deposit + overhead + risk premium Risk premium is used to pay for unexpected loss (UL) or NPF provisioning.
GAP = $50m - $1000m = -$950m FRA 1. BBA$700m 2.AITAB$400m 3. Tawaruq $100m Total$1200m RSA 1. Mudarabah$50m GAP = -$950 If profit rate decreases by 1%, then net income will increase by (-$950m x 0.01) = $9.5m RSL 1. WAD$200m 2. PSIA$800m Total$1000m RSL 1. WAD & PSIA $1000 GAP = -$950 If profit rate increases by 1%, then net income will fall by (- $950m x 0.01) = $9.5m.
To make GAP = 0 Increase RSA Decrease RSL But to decrease RSL will mean adding more fixed rate deposits (FRD). FRD = CMD, NICD. When GAP = 0, any changes in profit rate/interest rate will not affect income.
How to mitigate interest-rate risk in Islamic banking? Offering Floating-Rate BBA products BBA securitization Profit-rate Swap (PRS)
Floating Rate BBA/Murabaha Islamic Bank expects interest rate to increase. Set up the maximum rate Market rate = 5% Maximum rate = 10% (based on banks forecast) Cost of asset = $200,000 Tenure = 10 years Aqad price = $200,000 + ($200,000 x 0.1 x 10) = $400,000 Monthly payment = $400,000/120 = $3333. Selling price based on current rate = $200,000 + ($200,000 x 0.05 x 10) = $200,000 + $100,000 = $300,000 Monthly payment = $2500 = Actual payment Rebate = $3333 - $2500 = $833
Floating rate BBA/Murabaha If rate increases to 6%, SP = $200,000 + ($200,000 x 0.06 x 10) = $200,000 + $120,000 = $320,000 Monthly payment = $2666 Rebate = $3333 - $2666 = $667 Islamic bank able to adjust the rate since the aqad price remains the same based on the capping rate of 10%. As interest rate increases, rebate decreases.
Bank ABank B Fixed rate@Loan 10% @ Loan Floating rate@Loan BLR +1 @Loan Bank A expects interest rate to increase Bank B expects interest rate to fall Actual thing: interest rate increases Loan = $100m 1.Fixed Interest payment = 0.1 x $100m = $10 2.Floating interest payment = 0.12 x $100 = $12 million 3.Bank B pays Bank A $2 million. 4.No exchange of notional loan amount between Bank A and Bank B. Interest Rate Swap (IRS)
Bank ABank B Fixed rate@BBA 10% @ BBA Floating rate@BBA BLR +1 @ BBA Bank A expects interest rate to increase Bank B expects interest rate to fall Actual thing: interest rate increases Loan = $100m 1.Fixed profit-rate payment = 0.1 x $100m = $10 2.Floating profit rate payment = 0.12 x $100 = $12 million 3.Bank B pays Bank A $2 million. 4.No exchange of notional BBA amount between Bank A and Bank B. Profit Rate Swap (PRS)
Bank ABank B Sells asset in cash ie. notional resell asset @ notional + fixed rate Profit Rate Swap (PRS) Stage 1 Bank ABank B Pay fixed rate
Bank ABank B Sells asset @notional + floating rate (credit) resell asset @ notional (cash) Profit Rate Swap (PRS) Stage 2 Bank ABank B Pay floating rate
-ve Gap – Market risk RoR RoR DCR DCR risk mitigation PER Relationship between Market Risk and Displaced Commercial Risk
Rate of Return Risk Displaced Commercial Risk Profit Equalization Reserve Market Risk (Negative Income gap)
Commercial displacement risk (DCR) Deposits Expected rate of return < realized rate of return Customers may switch from Islamic deposits to conventional deposits To prevent deposit migration, Islamic bank uses its own reserves to top up the deficit. Total earning/profit declines.
Gap = RSA – RSL Positive Gap: RSA > RSL Positive Gap: (RSA/RSL) > 1 Negative Gap: RSA < RSL Negative Gap: (RSA/RSL) < 1 Credit based (Murabaha) Islamic bank: Most assets are fixed rate asset (FRA) or RISAs Most liabilities (Wadiah&Mudarabah) are RSLs. Islamic bank faces Negative Gap ; RSA < RSL
BBA Intensive Islamic Banks Most assets are fixed rate asset (FRA) or RISAs Most liabilities (Wadiah&Mudarabah) are RSLs. Islamic bank faces Negative Gap ; RSA < RSL
Potential loss arising from loss of deposits Gap/Asset-Liability Mismatches Rate of Islamic deposits < deposit interest rate Rd < id Actual rate of return < indicated/expected rate of return Rate of Return Risk Potential loss that occurs when Shareholders Funds are utilized to smoothen rate of return on Islamic deposits. Displacement Commercial Risk Amount appropriated out of total income to main an acceptable level of return on Islamic deposits. Serve to smoothen return on Islamic deposits (RoID). Increase PER provisions when RoID not competitive. Profit Equalization Reserve
Profit = ($100m x 0.07) – ($100 x 0.03) = $7m - $3m = $4m When market interest rates go up, what can happen to the bank? The bank cannot raise then profit rate to accommodate prevailing cost of fund. If it does, the murabaha contract turns invalid. The bank will lose deposits when Islamic deposit rate (IDR)< conventional interest rates (CII). When it losses deposits and forced to acquire money market funds at a higher cost, the bank earning drops. This is known as the Displaced Commercial Risk (DCR). To mitigate DCR, the Profit Equalization Reserve (PER) was instituted. PER serves to fill the gap between IDR and CII. Or the expcted rate of return and the realized rate of return.
Liquidity Risk Funding liquidity risk – a banks inability to mobilize deposits to satisfy withdrawals. Also referring to deposit concentration risk. Eg.
Asset Liquidity Risk Unable to execute transactions at the prevailing market price because there is no market appetite for the product. Inabiilty to dispose of the asset due to Shariah issues such as prohibitions of bay al-dayn (sale of debt)at discount. Deposit Liquidity Risk Overdependence on Corporate Deposits. Overall cost of deposits increases since corporates always demand higher rate of deposits on GIA. When an Islamic bank is overly dependent on corporate deposits, withdrawals due to maturities will create severe asset-liability mismatches. Cost overrun when the bank acquires funds from more costly money market sources such as Negotiable Islamic instruments (NII). LIQUIDITY RISK
Operational risk Potential loss resulting from inadequate systems, management failure, faulty controls, fraud and human error. Call for Board oversight to reduce operational risk.
Legal risk Legal risks becomes apparent when a counterparty or an investor, losses money on a transaction and decides to sue the Islamic bank to avoid meeting its obligation. Case in Malaysia: Datok Nik Vs BIMB In this way legal risk is synonymous with shariah risk
Shariah Risk Potential loss to the bank arising from cost of litigations against the bank as result of contract invalidation through the court of law. Shariah risk can be avoided by attending to: 1. Financial reporting requirement 2. Legal documentation requirement 3. Maqasid-Shariah requirement.
Shariah risk in Islamic Financial Instruments Financial reporting: prior to PSA, bank must hold ownership of asset. Recorded as fixed asset. Legal documentation: transfer of ownership from bank to customer. Warranties. Maqasid approach: benefits outweigh the disbenefits. Losses arising from money paid by Islamic bank to customers when contracts were found invalid in favour of customers. Form over substance. Contracts and legal documentation are not consistent. Eg. Sale with no transfer of ownership title. Sale without warranties Purchase undertakings in Musharakah sukuk.
Shariah risk Shariah risk is the potential loss to the Islamic bank arising from cost of civil actions carried or absorbed by the bank from lawsuits by customers. The cost of the civil actions may include: Compensations and damages paid to customers Returning profit collected from the Islamic facility Cost of court proceedings Reputation risk.
Shariah Risk There are two aspects of financial transaction involving Islamic banking business, namely: The concept of the transaction: This concerns whether the contract is based on sale, ijarah, wakalah, musharakah and other common contracts in Islamic banking, where the pillars ofaqd are central. The legal documentation of the transaction that spelt out the rights, responsibilities and obligations of the contracting parties. In essence, it defines the relationship between the bank and the customer. Usually the documentation is based on civil law.
Shariah Compliance: Consistency is Critical to avoid Shariah risk AQAD Principles AQAD Principles LEGAL/CONTRACT DOCUMENTATION Protection of Rights LEGAL/CONTRACT DOCUMENTATION Protection of Rights MAQASID Benefits vs disbenefits MAQASID Benefits vs disbenefits FINANCIAL REPORTING AAOIFI/IFSB/IFRS FINANCIAL REPORTING AAOIFI/IFSB/IFRS
Shariah Compliant Parameters Aqad-based – Contract-based Maqasid al-Shariah (purpose of the Law) – impact on society Financial Reporting – actual strength and performance of companies Legal documentation – identification and recognition of rights and obligations of contracting parties.
Approved Islamic Finance Products BBA Home Financing Bay Inah Home Financing Bay Inah Personal Financing/Overdraft/credit card Tawaruk munazam personal financing Commodity murabaha Ijarah thumma al-bay Bai-bithaman Ajil Islamic Debt Securities (BAIDS) Discounted Bay al-dayn MuNif Sukuk Ijarah Sukuk Musharakah
Challenging issues in AQAD-based Islamic Finance Products Benchmaking profit rate against interest rate (LIBOR,KLIBOR). Profit Equalization Reserve (PER) – displaced commercial risk Sale with condition to buyback at predetermined price between two and three parties. Profit generated over installment payments – time value of money Penalties on delayed payments Benchmaking sukuk rates against LIBOR Musharakah with Purchase undertakings – fixed profit to one party only. Ijarah Sukuk - Sale with repurchase agreement at par value and not mark-to market Ijarah Sukuk – Ownership of asset by SPV Profit-rate swaps – speculation or gambling?
Aqad Agents of Contract Objective of Contract Subject Matter Offer & Acceptance #1 AQAD Method
Sale (Al-Bay) Buyer & Seller Transfer of Ownership from Buyer to Seller Property Price set on the spot
Contract of Sale Example: Murabaha/BBA Sale 1. Buyer and Seller eg. Seller owns asset/subject matter before making sale 2. Subject matter eg. Mal mutaqawim – property with usurfruct 3. Price eg. Set on the spot 4. Offer & Acceptance eg. Verbal or in writing
Method #2: Maqasid al-Shariah/Objective of Shariah To protect the interest of the public (society)- maslahah al-ammah by: 1. removing the harm ( ibqa) 2. securing of benefits (tahsil)
Maqasid Shariah Removing the Harm Securing of Benefit #2 Maqasid Method
Objective of Shariah Islamic financial products as defined by AQAD methodology, should contain more benefits (masalih) and less or no harm (madarah). in gambling (maisir) and liqour (qimar), there are some sins and some profits. But the sins are greater than the profits (Al-Baqarah: 168).
Mudarat Sins Manfaat Profits in Gambling (maisir) and Liqour (qimar), there are some sins and some profits. But the sins are greater than the profits (Al- Baqarah: 168).
The upside (Manfaat) of Credit-Financing MACROMICRO Allocation of CapitalWealth creation Economic GrowthRich becoming richer Leisure, luxury and lifestyle
Maqasid To analyse(theoretical) and measure( empirical) impacts of financial intermediation based on aqad-based Shariah compliant products. 1. Efficiency studies 2. Profitability studies 3. Studies on Consumer welfare and protection 4. Studies on Financial stability
Maqasid – protecting public interest. Aqad-based products (ABP) SHOULD contain more benefits and less harm. What if, it was proven than they (ABP) contain more harm than good? eg. Abandon projects – customer cannot make recourse against bank as selling party? Defaulted BBA customer are required to make settlement based on the selling price. Sale with no transfer of ownership. Giving away clean inah personal financing at high profit rates– a way towards subprime inah? Conflict between Aqad and Maqasid?
Method #3: Financial Reporting Proper recording of transactions to evident TRUE SALE. BBA – bank must put BBA asset on balance sheet prior to sale. I week, 1 month it depends. Once sold, it is recorded as BBA receivables. AITAB assets should be on banking book as leasing assets but now treated as financing and advances. External auditors (PWC, KPMG etc.) are not required by the authority to conduct Shariah audit. And they may not be not capable to do so. Conflict between AQAD and financial reporting?
Islamic Bank Average Balance Sheet AssetsLiabilities Murabaha/BBAWadiah Dhamanah deposits AITABProfit Sharing Investment Acct Islamic Securities/SukukCapital
AssetsLiabilities FIXED ASSET 1. BBA asset 1.1/9/2008 Bank purchases Property from Vendor for $200,000 1.15/9/2008 Bank Sells Property to Customer for $280,000 AssetsLiabilities CURRENT ASSET 2. BBA Receivables 1 st October 2008 15 October 2008
BBA Legal Documentation 1. Sale and Purchase Agreement (SPA) 2. Property Purchase Agreement (PPA) 3. Property Sale Agreement (PSA) 4. Deeds of assignment/Charge 2. Bank do not have legal + beneficial ownership of property to make a valid sale Do not Sell what you don not Own Hadith (Sahih Bukhari) High Court Judge Datuk Abdul Wahab Patail says that the sale element in BBA sale is not a bona fide sale (Mayban Finance vs Taman Jaya) 1. No transfer of title from Customer to Bank
Method #4: Legal Documentation BBA should be documented as a true sale and not as a loan. (Dato Nik vs. BIMB) Ijarah should be documented as operating lease and not a loan (Tinta Press vs. BIMB) Islamic bank has not practice fairness compared with conventional bank (Affin bank vs Zulkifli). Conflict between AQAD and documentation of AQAD?
BBA Legal Documentation 1. Sale and Purchase Agreement (SPA) 2. Property Purchase Agreement (PPA) 3. Property Sale Agreement (PSA) 4. Deeds of assignment/Charge 2. Bank do not have legal + beneficial ownership of property to make a valid sale Do not Sell what you don not Own Hadith (Sahih Bukhari) High Court Judge Datuk Abdul Wahab Patail says that the sale element in BBA sale is not a bona fide sale 1. No transfer of title from Customer to Bank
Shariah Compliance: Consistency is Critical AQAD Principles AQAD Principles LEGAL/CONTRACT DOCUMENTATION Protection of Rights LEGAL/CONTRACT DOCUMENTATION Protection of Rights MAQASID Benefits vs disbenefits MAQASID Benefits vs disbenefits FINANCIAL REPORTING AAOIFI/IFSB/IFRS FINANCIAL REPORTING AAOIFI/IFSB/IFRS
Risk Measurement Credit risk –banking book Credit scoring, Stress Testing, non-performing financing (NPF) Market risk –trading book VaR Market risk – banking book Deposit-Asset mismatch,Gap, Duration models
Market Risk:Trading Book Value at Risk (VaR) Bank purchases securities for both holding and trading. For holding, the securities are recorded in the banking book. Potential loss in the banking book is measured by Earning at Risk (EAR) For trading, the securities are recorded in the trading book. Potential loss in the trading book is measured by Value at Risk (VaR)
Bond Trading Bond Price = Coupon / interest rates Price = $1000 per unit i= 10% Coupon = $100 $1000 = $100/0.1 An investors is deciding whether to purchase bond or not. He will only buy bond in order to make capital gain. Thus, he must buy low and sell high. If he expects, interest rate to increase, he will not buy the bond. This is because the bond price will fall and he losses out. Example: Buy at $1000. When interest rate increases to 20%, bond price will fall; $500 = $100/0.2. He buys at $1000 per unit and now the bond market value at $500. Loss = $500. VaR – what is the maximum loss the investor can absorb?
Bond Trading Bond Price = Coupon / interest rates Price = $1000 per unit i= 10% Coupon = $100 $1000 = $100/0.1 An investors is deciding whether to purchase bond or not. He will only buy bond in order to make capital gain. Thus, he must buy low and sell high. If he expects interest rate to fall, he will buy the bond. This is because he will make profit since the bond price now increases. Example. $1000 = $100/0.1. When interest rate indeed fall down, say to 5%, bond price will increase to $2000. He will make a capital gain of $1000. $2000 = $100/0.05.
VaR The senior management is told that there is 1 in 100, say, chance of losing X dollars over the holding period. It means that there is a 1% chance that the bank will lose $50 million over 1 year. Var = $50m at 95% confidence interval implies that there a 5% possibility that the bank may lose $50m.
VaR A VAR statistic has three components: 1. a time period, 2. a confidence level and 3. a loss amount (or loss percentage). Keep these three parts in mind as we give some examples of variations of the question that VAR answers: What is the most I can - with a 95% or 99% level of confidence - expect to lose in dollars over the next month? What is the maximum percentage I can - with 95% or 99% confidence - expect to lose over the next year? You can see how the "VAR question" has three elements: a relatively high level of confidence (typically either 95% or 99%), a time period (a day, a month or a year) and an estimate of investment loss (expressed either in dollar or percentage terms).
Value at Risk (VaR) VaR is potential loss VaR is the maximum loss at a preset confidence interval Confidence interval reflects the risk appetite of the bank Confidence interval is also the probability that the loss exceed capital of the bank, triggering bank insolvency. Confidence interval is equivalent to the default probability of the bank. VaR shines for 3 main reasons: 1. it provides a complete view of portfolio risk 2. it is the basis of measuring economic capital 3. VaR assigns a dollar value to risk ………
VaR and Its Application Senior management is told that there is 1 in 100, say, chance of losing X dollars over the holding period. There is a 1% chance that the bank will lose $50 million over 1 year. VaR= $50m at 99% confidence interval implies that there a 1% possibility that the bank may lose $50m. VaR is potential loss, thus when a VaR limit become binding, it will put pressure on the banks trading business to lower their risks. For example, the trading book = $200 billion and the VaR is $40 million. It means that there is 1% possibility that the bank may lose $40m from the trading book valued at $200 billion. Usually, if the economy gets worse, VaR limit will be lowered.
Estimating VaR Variance- covariance Risk factors can be correlated The historical simulation Risk factors based on past events Monte Carlo simulation Risk factors as random
Stress Test: Serves to complement VaR VaR is used to provide a probabilistic prediction on losses that are likely to happen for a pre-specific holding period and confidence level. It is difficult to ensure that by using Var, extreme cases are fully covered. The purpose of stress testing is to determine the size of potential loss related to specific scenarios or extreme cases. The selection of scenarios is largely based on expert judgment. Stress testing show us how vulnerable a portfolio might be to a variety of extreme events. Stress testing can be conducted on stand alone basis ie. without VaR.
Stress testing ST is a standard risk management technique used to identify and quantify possible events of future changes in the financial and economic conditions that could have unfavourable effects on the Banks exposure. Conceptually, a ST is an approach to revalue a portfolio using different set of assumptions. The objective is to better understand the sensitivity of the portfolio to changes in various risk factors. This change is often expressed in terms of impact on some measure of bank earning, profitability and asset quality to understand its sensitivity to the risk factors being considered.
ActualStress Test Baseline Stress Test Plausible Stress Test Worse P & L Capital Base$50b$48b$40b$35b RWA RWCR15%13%11%9% NPF7%8%9%11%
Worse case risk factors High NPL Low Profit Slow capital growth Stress Test
Risk-Factors GDP CPI BLR Unemployment rate Retail Index Property Index
Sensitivity Tests Instead of doing financial projection on a "best estimate" basis, a company may do stress testing on capital, NPF etc. where they look at how robust a financial instrument is in certain crashes. They may test the instrument under, for example, the following stresses: What happens if the market crashes by more than x% this year? What happens if interest rates go up by at least y%? What if half the instruments in the portfolio terminate their contacts in the 5th year? What happens if oil prices rise by 200%?
Sensitivity test Asses the impact of large movements in financial variables on portfolio without specifying the reasons for such movements Example 10% drop on the stock market indexes
Scenario Tests Constructed in the light of historical events or in the contexts of a specific portfolio Eg. Large US stock market decline 1987, Asian financial crises 1997, Russion default 1998, September 11 2001
Stress Test : How can changes in economic fundamentals affect banks capital? Extreme Scenarios Changes in interest rates Changes in exchange rates Changes in Equity prices Changes in commodity prices
Stress Test Credit Risk The Baseline case 1% increase in NPL 2% increase in NPL
Adverse macroeconomic scenarios Client Default Credit Loss Bank Loss Capital Erosion Bank Failure Credit Crunch Recession Whats Next?
Basel II Financial Stability: Bank Capital Requirement
Shariah Framework Islamic Banking Bank Negara Shariah Supervisory Board AAOIFIFiqh Academy
Regulatory Framework Islamic banking Basel II Islamic Financial Service Board
Basel II Minimum Capital Requirement Supervisory Review Market Discipline 1.Standardized Based Approach 2.Internal Based Rating Approach
Basel II The objective of Basel II is to protect depositors fund through an international standard concerning how much capital banks need to put aside to guard against losses arising from exposures to risks. This is done by establishing rigorous risk and capital management requirements designed to see that the bank holds sufficient capital reserves appropriate to the risk it is carrying through its lending and investment practices. Hence, the more the bank is exposed to risk, the greater is the amount of capital the bank needed to back up the assets. The three pillars if Basel II is shown in the following diagram: 3 Pillars of Basel II Minimum capital Requirement Supervisory Review Market Discipline
Basel II The objective of Basel is to protect the depositors since deposits mobilization is based on creditor- debtor contract. Loss due to default affects Banks capital Insufficient banks capital leads to bank runs and foreclosure – financial instability. Thus, bank must hold sufficient capital as a back up to the amount of money they owe depositors
Basel II Ratio Capital Adequacy Ratio (minimum = 8%) Total Capital CAR = Total Capital / (Credit risk + Market risk + Operational Risk) Risk-Weights Risk weight assets are the sum of asset subject to market, credit and operational risk.
Pillar 1: Capital Requirement The first pillar deals with maintenance of regulatory capital calculated for three major components of risk that a bank faces: 1. credit risk1. credit risk – potential loss arising from non-performing loans and bad debts 2.operational risk2.operational risk – potential loss arising from system and human error in running banking operation 3. market risk3. market risk. – potential loss caused by market volatilities that may erode value of investment in securities. 4. The credit risk component can be calculated in three different ways of varying degree of sophistication, namely:credit risk A) Standardized ApproachA) Standardized Approach: The risk-weights are based on available external credit ratings, say set by the regulatory authority or rating agencies. B)Foundation Internal Rating-Based Approach (IRBB)Foundation Internal Rating-Based Approach (IRB): The risk-weights set by the bank (i.e PD) and LGPD set by the regulators. C) Advanced Internal Rating-Based Approach (IRB) For operational risk, there are three different approaches - basic indicator approach or BIA, standardized approach or TSA, and advanced measurement approach or AMA.operational riskbasic indicator approach standardized approachadvanced measurement approach For market risk the preferred approach is VaR (value at risk).market riskvalue at risk
Capital Requirement The capital requirement is a bank regulation, which sets a framework on how banks and depository institutions must handle their capital.bank regulationbanks depository institutionscapital The categorization of assets and capital is highly standardized so that it can be risk weighted. Internationally, the Basel Committee on Banking Supervision housed at the Bank for International Settlements influence each country's banking capital requirements. In 1988, the Committee decided to introduce a capital measurement system commonly referred to as the Basel Capital Accords (Basel Accord).Basel Committee on Banking SupervisionBank for International SettlementsBasel Capital AccordsBasel Accord This framework is now being replaced by a new and significantly more complex capital adequacy framework commonly known as Basel II. While Basel II significantly alters the calculation of the risk weights, it leaves alone the calculation of the capital. The capital ratio is the percentage of a bank's capital to its risk-weighted assets.Basel IIcapital ratioassets Weights are defined by risk-sensitivity ratios whose calculation is dictated under the relevant Accord.
Commercial Banks Standardized Rating Based Banks Risk weights sets by regulators and external credit rating agencies Internal Rating Based Banks Risk-weights sets by Bank and Regulator Determination of Capital Requirement in Basel II
Capital Requirement Tier 1 capital is the core measure of a bank's financial strength from a regulator's point of view. It consists primarily of 1) shareholders' equity but may also include preferred stock that is irredeemable and non-cumulative and 2) retained earnings.bankregulatorpreferred stock retained earnings
Pillar 2 : Supervisory Review The second pillar deals with the regulatory response to the first pillar, giving regulators much improved 'tools' over those available to them under Basel I. It also provides a framework for dealing with all the other risks a bank may face, such as systemic risk, pension risk, concentration risk, strategic risk, reputation risk, liquidity risk and legal risk, which the accord combines under the title of residual risk.It gives bank a power to review their risk management system.regulatorssystemic riskpension riskconcentration risk strategic riskreputation riskliquidity risklegal risk
Pillar 3: Market Discipline The third pillar greatly increases the disclosures that the bank must make through regular financial reporting to the bank supervisors. This is designed to allow the market to have a better picture of the overall risk position of the bank and to allow the counterparties of the bank to price and deal appropriately.disclosuresmarketcounterparties
Impact of Basel II on Islamic Banking Capital Requirement Uneven Playing Field
Standardized Approach: Conventional Bank Assets Amount Riskweights RWassets Loans $600m50%$300 Hire-Purchase$300m50%$150 Personal Loans$200m100%$200 Bond$100m50%$ 50 TOTAL$1200 $700 Capital ratio = (Regulated Capital / RWA) 8% = RC / $700 RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5)] = $300m + $150m +$200m + $50m = $700 RC = $700 x 0.08 = $56m Note Risk weight also known as conversion factor. Risk-weights set by external rating institutions and regulators.
Standardized Approach: Conventional Bank : Exercise 1 Assets Amount Riskweights RWassets Loans $ 1200m50%$ Hire-Purchase$600m50%$ Personal Loans$300m100%$ Bond$200m50%$ TOTAL$1200 $ Capital ratio = (Regulated Capital / RWA) 8% = RC / $700 RWA = [($1200m x 0.5) + ($600m x 0.5) + ($300m x 1.00) + ($200 x 0.5)] = $ RC = Note Risk weight also known as conversion factor. Risk-weights set by external rating institutions and regulators.
Islamic Bank Under Basel 2: Higher Capital Requirement Assets Amount Riskweights RWassets Murabaha$600m50%$300 AITAB$300m50%$150 Personal F$200m100%$200 Sukuk$100m50%$ 50 TOTAL$1200 $700 Capital ratio = (Regulated Capital / RWA) 8% = RC / $700 RWA = [($600m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5)] = $300m + $150m +$200m + $50m = $700 RC = $700 x 0.08 = $56m Note Risk weight also known as conversion factor.
Islamic Bank with Musharakah financing under Basel 2: Higher Capital Requirement Assets Amount Riskweights RWassets Murabaha$500m50%$250 AITAB$300m50%$150 Personal F$200m100%$200 Sukuk$100m50%$ 50 Musharakah $100m 250% $250 TOTAL$1200 $900 Capital ratio = (Regulated Capital / RWA) 8% = RC / $900 RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5) + ($100 x 2.5)] = $250m + $150m +$200m + $70m + $250 = $900 RC = $900 x 0.08 = $72.00m Note Risk weight also known as conversion factor.
Stress on Islamic bank capital Since the risk-weight for Musharakah is 250%, the bank is charged higher capital from $56m to $78m. The bank has to come up with $22m more capital to meet regulators requirement in order to undertake the Musharakah project. In this sense, the Musharakah project places stress of Islamic bank capital. Basel II assumes that Islamic deposits are similar with conventional deposits. In conventional deposits, the deposits and interest income are guaranteed. This is not the case for Islamic deposits since they are based on profit-sharing system. In this manner, the bank need not provide capital guarantees.
Bank Negara Malaysia (BNM) Guidelines on Profit-Sharing Investment Account (PSIA) with risk absorbent In order to highlight the more accurate nature of mudarabah deposits (PSIA) and its impact on bank capital, BNM has provided a new formulation for determining regulated for Islamic banks. PSIA will be used to finance a relatively more risky projects based on mudarabah, istisna and musharakah contracts. The formulation capital adequacy ratio (CAR) = Capital/ (RWA less (1- α )RWA funded by PSIA less ( α )RWA in the form of PER) When α = 1, the bank holds all risks in the balance sheet. When α is say 30%, the bank carry risks only from wadiah dhamanah deposits and general mudarabah deposits. Then 70% of the risks (1- α ) = (1-0.3), is carried by PSIA deposits. Then CAR will be less than CAR without α as a risk-absorbent factor. This will reduce stress on Islamic banking capital. Hence, the smaller the α i.e. the more risks carried by PSIA, the lower is the CAR.
Modified Formula Incorporating the Risk nature of Mudarabah Deposits RWCAR Islamic = [Capital Base] /[(TRWA Islamic ) Less (1- ) (Credit and Market Risk Weighted Asset funded by PSIA) Less ( )(proportional of Credit and Market Risk Weighted Assets funded by PSIA in the form of PER)]
Islamic Bank with Musharakah financing under Basel 2: Higher Capital Requirement Assets Amount Riskweights RWassets Murabaha$500m50%$250 AITAB$300m50%$150 Personal F$200m100%$200 Sukuk$100m50%$ 50 Musharakah $100m 250% $250 TOTAL$1200 $900 Capital ratio = (Regulated Capital /( RWA – [1- α]RWA funded by PSIA –[α] RWA funded by PSIA as PER ) 1.α= 30% 2.(1-α) = 70% 3.RWA funded by PSIA = $250m (musharaka) 4.RWA as PER = $2m (by assumption) RWA = [($500m x 0.5) + ($300m x 0.5) + ($200m x 1.00) + ($100 x 0.5) + ($100 x 2.5)] = [$250m + $150m +$200m + $70m + $250] - (0.7)($250) – (0.3)($2) = $900m - $175m - $0.6m = $724.4m RC = $724.4 x 0.08 = $57.95m Note Risk weight also known as conversion factor. PER = Profit Equalization Reserve.
(1- ) represents the quantum of PSIA recognized as a risk absorbent for RWCR computation purposes and approved by Bank Negara Malaysia. = 1 means all risks carried by bank = 0 means all risks carried by PSIA. The smaller the, the lower is RWCR.
Scandals and failure of energy giant Enron, WoldCom and Global Crossing and now the Subprime Banking crises in the USA that saw the fall of giant Lehman,Morgan Stanley,AIG etc. Corporate Governance and Risk Management: Basel II Pillar 3 on Market Discipline
Basel II Pillar 3 Aims at strengthening market discipline, i.e the pressure that financial markets may exert on bank managers so as to promote safe and sound bank management. Pillar 3 defines a number of disclosures requirements aimed at increasing the transparency of each banks risk profile and risk policy.
Corporate Governance Boards were provided with misleading information Breakdown in the process by which information was transmitted to the board and shareholders. Breakdown involving financial engineering and nondisclosure of economic risks Outright fraud. Regulatory authorities must upgrade work to protect all stakeholders. Legislations to mend perceived failures in corporate governance practices.
Board and Corporate Governance The primary responsibility of the board is to ensure that it develops a clear understanding of the banks business strategy and the fundamental risks and rewards it implies. The board must make sure that risks are transparent to managers and to stakeholders through adequate internal and external disclosure The board must characterize an appropriate risk-appetite for the firm. system of limits and risk metrics.
Business Strategy, Board and Risk Management 1. Avoid risk by choosing not to undertake some activities. 2. Transfer risk to third parties through insurance, hedging and outsourcing, subject to Shariah rules. 3. Mitigate risk such as operational risk, through preventive and detective control measures. 4. Accept risk, recognizing that undertaking certain risky activities should generate shareholder value. Board should ensure that business and risk management strategies are directed at economic rather than accounting performance. Board must make sure that the bank has put in place an effective risk management program that is consistent with these fundamental strategic and risk appetite choices. It must make sure that there are effective procedures in place for identifying, assessing and managing all types of risk ie. business risk, operational risk, market risk, liquidity risk, credit risk, shariah risk, rate of return risk and displaced commercial risks.
Basel II and IFSB High risk-weights for Musharakah Financing to imply that bank bears business risk and the general investment account holders (GIA) do not. Recent PSIA guidelines will test risk appetite of depositors.
Limits and Limits Standard Policies. Market-risk limits serve to control the risk that arises from changes in the absolute price (or rate) of an asset. Credit risk limits serve to control and limit the number of defaults as well as limiting a downward migration in the quality of the credit portfolio. It is best practice for institutions to set down on paper the process by which they establish risk limits, review risk exposures, and approve limit exceptions and to develop an analytical methodology used to calculate the banks risk exposures. For many banks, best practice risk governance will call for the development and implementation of sophisticated risk metrics such as value at risk (VaR) measures for market and credit risk.
Principle 1.0 : IIFS shall have in place a comprehensive risk management and reporting process, including i) appropriate board and senior management oversight, ii) to identify, measure, monitor, report and control relevant categories of risks and, where iii) appropriate steps to comply with Shariah rules and principles and iv) to ensure the adequacy of relevant risk reporting to the supervisory authority.
Principle 2.1 :IIFS shall have in place a strategy for financing, using various instruments in compliance with Shariah, whereby it recognises the potential credit exposure that may arise at different stages of the various financing agreements.
Principle 2.2 : IIFS shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrument.
IFSB Credit Risk Principle 2.3 IIFS shall have in place appropriate methodologies for measuring and reporting the credit risk exposure arising under each Islamic financing instrument.
IFSB Credit Risk Principle 2.4 IIFS shall have in place Shariah compliant credit risk mitigating techniques appropriate for each Islamic financing instrument.
KEY OBJECTIVES OF CAS Sets out a common structure for the assessment of Islamic Institutions Offering Financial Services (IIFS) capital adequacy requirements, which will support transparency and consistent methodology for all IIFS. A common approach without compromising Shariah rules and principles by substantially enhancing the transparency of true obligations within IIFS operations. Promotes a level playing field at a global level as far as common assessment is concerned especially for the minimum capital requirements in respect of both credit and market risks arising from each financing mode at different stages of a contract. Recognition of investment account holders account holders (IAH) as partners in IIFS operations should result in a more effective use of capital.
To ensure that Islamic banks can absorb a reasonable level of losses before becoming insolvent. To provide protection to depositors and/ or PSIA – the higher the CAR, the higher the level of protection. To promote stability and efficiency of the financial system by reducing the likelihood of Islamic banks become insolvent. To ensure that the Islamic banks capital position commensurate with its overall risk profile and strategy.
GENERAL PRINCIPLES OF CAS IIFS are required to use the substance of the Shariah rules and principles governing the contracts to form the basis for an appropriate treatment in deriving their minimum capital adequacy requirements. Capital adequacy requirements vary according to the transformation of risks at different contract stages.
On basis of either Mudarabah or Wakalah contract, credit and market risks of the investment made by the IAH shall normally be borne by themselves, while the operational risk is borne solely by the IIFS (unless proven negligence, mismanagement or fraud).
Credit risk is measured according to the Standardised Approach of Basel II, except for certain exposures arising from investments by means of Musharakah or Mudarabah contracts in assets that are not held for trading. Until adequate historical data are available, the IFSB employs Basels risk weights.
Apart from market risk exposures arising from equity, foreign exchange, commodities, the exposures also include trading positions in sukuk and inventory risk, which results from IIFS holding assets with a view to re selling or leasing them. In the case of equity investment made by means of Musharakah or Mudarabah contract where the underlying assets are commodities held for trading, market risk provisions for commodities are applicable. For inventory risk, only simplified approach is applicable.
Shariah noncompliance risk is a type of operational risk facing the IIFS which can lead to non recognition income and resultant losses. The extent of losses from non compliance with Shariah rules and principles cannot be ascertained owing to lack of data. Supervisory authorities have discretion to impose a RW higher than 15% as they deem fit to cater for the Shariah noncompliance risk of a particular IIFS.
GUIDING PRINCIPLES ON CORPORATE GOVERNANCE FOR INSTITUTIONS OFFERING ONLY ISLAMIC FINANCIAL SERVICES (EXCLUDING ISLAMIC INSURANCE (TAKAFUL) INSTITUTIONS (IIFS) AND ISLAMIC MUTUAL FUNDS)
Principle 1.1 : IIFS shall establish a comprehensive governance policy framework which sets out the strategic roles and functions of each organ of governance and mechanisms for balancing the IIFSs accountabilities to various stakeholders.
IFSB Guiding Principles on Corporate Governance Principle 1.2 IIFS shall ensure that the reporting of their financial and non-financial information meets the requirements of internationally recognised accounting standards which are in compliance with Shariah rules and principles and are applicable to the Islamic financial services industry as recognised by the supervisory authorities of the country.
Principle 2.1 : IIFS shall acknowledge IAHs right to monitor the performance of their investments and the associated risks, and put into place adequate means to ensure that these rights are observed and exercised.
Principle 2.2 :IIFS shall adopt a sound investment strategy which is appropriately aligned to the risk and return expectations of IAH (bearing in mind the distinction between restricted and unrestricted IAH, and be transparent in smoothing any returns.
Principle 3.1 : IIFS shall have in place an appropriate mechanism for obtaining rulings from Shariah scholars, applying fatawa and monitoring Shariah compliance in all aspects of their products, operations and activities.
Principle 3.2 :IIFS shall comply with the Shariah rules and principles as expressed in the rulings of the IIFSs Shariah scholars. The IIFS shall make these rulings available to the public
Principle 4 : IIFS shall make adequate and timely disclosure to IAH and the public of material and relevant information on the investment accounts that they manage.