Expert View Regulation & Risk

Managing Unique Risk

Change is an essential part of life and involves risk. Shying away from change is a risk by itself. Business is a course of life? so in life & business there lie a variety of risks. Therefore? risk is inevitable and the best an individual or institution could do is to manage it well.

Financial industry is no exception and Islamic financial institutions have no choice but to continuously evolve the art of risk management that best suits the institution and the industry at large. If we analyse the very basics of the business of banking, there are three entities, which are at the core of it— (1) Have (2) Have-nots (3) Connect between Have and Have-nots. Each of these confronts dual risk – an isolated risk plus a joint risk with either of the entity. For instance, “Have” is concerned whether his surplus wealth will grow or diminish. “Have-nots” are concerned whether they will be able to meet their needs, wants and desires. ’The connect between “Have” and “Have—not’s ”which is usually a banking entity is concerned whether its dual commercial relationship with the “Have” and “Have-nots” will be able to yield desirable results. ’This is primarily the case with any financial institution.

However, an Islamic Financial Institution (IFI) has an additional concern to be addressed i.e. the genuinity of source of surplus wealth that “Have” possesses and the genuinity of the purpose for which its identified have nots will use it, should it decide to play the role of an intermediary between these entities. Simply put in language of the industry, a question to which there cannot be an answer other than Yes for an IFI is whether the economic activity that backs any potential transaction is “Shari’a Compliant”? Let’s simplify the concept of risk and build an understanding around it.

In simple terms, risk is probability of failure and risk management is a series of steps one should take so as to reduce this probability of failure. In the game of cricket, a team could choose to be in an attacking or defensive mode, depending upon the prevailing circumstances. ’There are pros and cons of each. Deploying a leg spinner on the job may offer the opportunity to strike back and claim a wicket and break a nurturing partnership, however, at the same time it also carries the risk of being taken for granted and devastated by the batsman in all corners of the ground, more often than not via the aerial route. Similarly, an IFI shall carefully evaluate the opportunities it discovers as a part of its commercial journey. A million dollar question worth asking is—Am I doing the right thing or just the thing right? Am I being values focused or values neutral? ’ The risk management of an IFI is a function of nature of people and purpose that determines the transaction. “Due Diligence” to be performed by the IFI holds an important key when it comes to determining the quality of risk management. For instance, in a Murabahah transaction, an IFI should  carefully evaluate the purpose for which its customer shall use its funds.

When the bank appoints customer as its agent who make a purchase on behalf of the bank, not only does the bank satisfies its customer’s needs more closely, but also manages its risk by being totally aware on what is being bought by using its funds? Similarly, in a Mudarabah transaction it is vital to note that in the event of loss, it will be borne by the fund provider (rab-ui-mal) and not the Mudarib who losses his time and effort. Such provisions make sure that the business of banking and financial services offered by an Islamic bank is very practical and hence feasible. Due Diligence also involves certain domain specific analysis such as, if the funds are sourced from or being directed to a financial institution, then the latter shouldn’t have exposure to interest bearing instruments. If this due diligence fails to dick, then the IFI carries a reputational risk because it doesn’t comply with Shari’a principles in word, spirit and intent and no longer will be an attractive proposition for those who look for these qualities in their banking and financial services provider. Islamic finance in its offerings like Takaful carries ail those risks, which an insurance provider in general has to bear, plus also some additional risks like Shari’a compliance risk, which are unique to the industry. Islamic finance carries yet another unique risk called “perception risk’. ‘This primarily relates to the scope and applications of Islamic finance and include curious queries like whether Islamic finance have embedded sufficient controls so as to keep itself isolated from clutches of some unpopular international developments related to certain geographies. Another curious question that Islamic finance professionals and practitioners are often confronted is whether Islamic finance is meant only for Muslims or could people from other religions also leverage its services. The answer is undoubtedly “Yes”, however, a certain element of doubt that pre-exists often keep new customers away from the banks.  It’s a hollow assumption, which cause certain opportunities to be missed.  from a technical stand point ,like many other financial institutions liquidity is an important concern and risk that an IFI faces quite often .Asset quality is yet another element of risk that needs proper address by the IFI. Yet another unique risk that an IFI faces is “Whether its Shari’a board is taking consistently good decisions” or not? At the same time, Shari’a board has to be consistent in its approach and its view towards transactions.  The decision shouldn’t be a surprise to the investors. Much has been discussed about the lack of standardisation in the Islamic finance industry at various levels. Islamic banks in two different countries may approve or reject of the same given transaction, depending upon the school of thought being followed in the country by the IFI. Moreover, there have been instances where the same bank has approved or rejected any given transaction at different intervals, depending upon the hearing of the case. Such instances may make the business environment unpredictable.

Let us try to conclude by recommending some of the steps that an IFI must take so as to ensure a strong risk management framework for itself and the broader industry.

  1. Trust but verily — Due diligence around the nitty-gritty of any given transaction is very important to be verified. Trust builds foundation but that foundation needs to be correct.
  2. Make original mistakes —As a part of learning curve there are instances where Financial Institutions can go wrong. However, it is important to ensure that first wrong isn’t followed by yet another wrong.
  3.  Learn from the mistakes of peers —Not necessary that a mistake from which an institution strives to learn has to originate within itself. A smarter way forward would be to learn from mistakes of others and not to make them ourselves.
  4.  From an HR perspective focus on building a culture of nurturing wisdom in decision making, as much as the role of skill and training. A Shari’a law violation could happen if wisdom isn’t applied at the right time.
  5. Make the right and informed decisions — For instance, if we talk about the technology infrastructure of an Islamic bank, there are plenty of choices available in terms of CBS — Core Banking Solutions. However an IFI should consider factors like its key strengths and attempt to marry those with strengths of potential software solutions.
  6. Stay ahead and stay connected —An IFI not only compete with other IFI’s but also other FT’s. So, an IFI shall pay dose attention to other IFI’s and FT’s both. By doing so, best practices sharing between IFI’s could be a remote reality. To grow is good news, but if the pace of growth is not maintained then it is a bad news, primarily because others did a better job. In such circumstances, it is poor risk management that leads to bad news. Islamic finance has impressed the world for good reasons so far. It has set examples of some very progressive Fl’s , which made the world believe that “It is not the bier institution that is going to dominate the smaller institution”; instead, the real competition is between slower and faster institutions, and the latter is all set to create history

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