2. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15th December 2004 Warren Edwardes, ceo, Delphi Risk Management Limited email: we@dc3.co.uk web: dc3.co.uk

3. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes Delphi’s website contains: articles on Islamic banking on: dc3.co.uk/islamicbanking This PowerPoint is on: dc3.co.uk/islamicfinancerisk041215.ppt with notes on dc3.co.uk/islamicfinancerisk041215.pdf Speech drawn from the book "Key Financial Instruments" Appendix 1 (50 Risk types) –dc3.co.uk/risks.htm Appendix 4 (Islamic banking) –dc3.co.uk/islamicbanking.htm

4. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes financial risk some actions can protect the same actions can destroy risk – a film

5. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes

6. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes 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 ? –Repos / Murabaha ? –Fund management ? Islamic Banking is ALL about who bears risk

7. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes A check-list of 50 banking risk types To put it simply and directly, if the bosses do not or cannot understand both the risks and rewards in their products, their firm should not be in the business. - William J. McDonough, President, Federal Reserve Bank of New York

8. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 1-4 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?

9. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 5-8 Communication Risk –Define terms clearly –Deposit or managed funds? Country Risk –much of Islamic banking is carried out in emerging markets. Riskier? Pakistan 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

10. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types – 9-12 Currency Transaction Risk –use of derivatives generally not allowed? 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. So can Malaysia compete with USD based countries when the USD depreciates? Customer Satisfaction Risk –If a bank pays no dividends customers will get angry

11. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 13-16 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?

12. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 17-20 Equity Market Risk –Islamic banking is ideally profit and loss sharing. This is venture capital or equity investment Fraud (banker) Risk –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 –Haram for lenders to seek material benefit. BCCI was not an Islamic bank but fraud could occur in Islamic banks

13. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 21-24 Image / PR Risk –Something hallal could be deemed haram. Sep 11 was bad PR for Islamic banks Information Risk –Lack of transparency in accounts in many Islamic countries 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

14. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 25-27 Interaction Risk –Correlation risk. What happened in New York and Baghdad impacts on KL. Gold standard? 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

15. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 28-30 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?

16. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 31-34 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; boycotts by Western banks Competence / Understanding –Are the latest products really understood by the banks’ senior management? By the customers?

17. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 35-38 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 –Do you have enough investors or do you depend on one or two? Concentration of business type Risk –Financial supermarket or nimble niche player are both fine. But can you reinvent yourself if markets change? –Can you cope with the entry of HSBC / Barclays / Citibank? Convertibility Risk –Deliverability risk under exchange controls

18. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 39-42 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 Religious Risk –A Hallal product may later be deemed Haram. Zero coupon bonds were once Hallal. Other than Malaysia no Central Shari’ah authority

19. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types - 43-46 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 VAT? Income tax or capital gains tax treatment?

20. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes banking risk types – 47-49 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? KL’s 1998 smog and Kuwait’s burning oil fields probably had an adverse impact on employees health. –Weather derivatives are being traded. Haram? Weather Takaful?

21. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 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

22. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes Particular 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

23. Risk characteristics of Islamic financial products Institute of Islamic Banking & Insurance London 15 th December 2004 Warren Edwardes Risk Issues In Islamic Banking