IFSB Standard Guidelines

1
IFSB Standard Guidelines
Capital Adequacy Standard, Risk Management and
Governance
IFSB Standards IRTI Distance Learning Program
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I. Introduction
Islamic Financial Services Board
The IFSB, which is based in Kuala Lumpur, was
officially inaugurated on 3rd November 2002 and
started operations on 10th March 2003. It serves
as an international standard-setting body of
regulatory and supervisory agencies that have
vested interest in ensuring the soundness and
stability of the Islamic financial services
industry, which is defined broadly to include
banking, capital market and insurance. In
advancing this mission, the IFSB promotes the
development of a prudent and transparent Islamic
financial services industry through introducing
new, or adapting existing international standards
consistent with Shari'ah principles, and
recommend them for adoption.
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I. Introduction
Islamic Financial Services Board
IFSB-1 Guiding Principles of Risk Management
for Institutions (other than Insurance
Institutions) offering only Islamic Financial
Services (IIFS) IFSB-2 Capital Adequacy
Standard for Institutions (other than Insurance
Institutions) offering only Islamic Financial
Services (IIFS) IFSB-3 Guiding Principles on
Corporate Governance for Institutions offering
only Islamic Financial Services (Excluding
Islamic Insurance (Takâful) Institutions and
Islamic Mutual Funds IFSB-4 Disclosures to
Promote Transparency and Market Discipline for
Institutions offering Islamic Financial Services
(excluding Islamic Insurance (Takâful)
Institutions and Islamic Mutual Funds) IFSB-5
Guidance on Key Elements in the Supervisory
Review Process of Institutions offering Islamic
Financial Services (excluding Islamic Insurance
(Takâful) Institutions and Islamic Mutual Funds)
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I. Introduction
Islamic Financial Services Board
IFSB-6 Guiding Principles on Governance for
Islamic Collective Investment Schemes IFSB-7
Capital Adequacy Requirements for Sukuk,
Securitisations and Real Estate investment
IFSB-8 Guiding Principles on Governance for
Takâful (Islamic Insurance) Undertakings IFSB-9
Guiding Principles on Conduct of Business for
Institutions offering Islamic Financial
Services IFSB-10 Guiding Principles on Shariah
Governance Systems for Institutions offering
Islamic Financial Services IFSB-11 Standard on
Solvency Requirements for Takâful (Islamic
Insurance) Undertakings
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I. Introduction
Islamic Financial Services Board
GN-1 Guidance Note in Connection with the
Capital Adequacy Standard Recognition of Ratings
by External Credit Assessment Institutions
(ECAIs) on Shariah-Compliant Financial
Instruments GN-2 Guidance Note in Connection
with the Risk Management and Capital Adequacy
Standards Commodity Murâbahah Transactions GN-3
Guidance Note on the Practice of Smoothing the
Profits Payout to Investment Account
Holders GN-4 Guidance Note in Connection with
the IFSB Capital Adequacy Standard The
Determination of Alpha in the Capital Adequacy
Ratio for Institutions (other than Insurance
Institutions) offering only Islamic Financial
Services
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I. Introduction
Solvency
Networth
Islamic bank
CAS
Sukuk and securitization
External rating
Alpha
Commodity Murbaha
Takaful operators
CAS
External rating and retakaful
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I. Introduction
Risk Management
GP - Islamic bank
Liquidity risk
Sress testing
Corporate Governance
GP - Islamic bank
GP - Takaful
GP Collective funds
Sharia Governance
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II. Capital adequacy
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II. Capital adequacy
Standard formula
Eligible capital
CAR
RWA(CM)RWA(O)-RWA(CM)PSIA
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II. Capital adequacy
Eligible capital

• Tier 1 capital
• Common Stock
• Retained Earnings
• Tier 2 capital
• Undisclosed reserve
• Asset revaluation reserve
• General provisions
• Loan loss reserves
• Hybrid instruments (debt/equity)
• Subordinated term debts

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II. Capital adequacy
RWA 1 Murabahah

• A Murabahah contract refers to an agreement
  whereby the IIFS sells to a customer at
  acquisition cost (purchase price plus other
  direct costs) plus an agreed profit margin, a
  specified kind of asset that is already in its
  possession.
• An MPO contract refers to an agreement whereby
  the IIFS sells to a customer at cost (as above)
  plus an agreed profit margin, a specified kind of
  asset that has been purchased and acquired by the
  IIFS based on an Promise to Purchase (PP) by the
  customer which can be a binding or non-binding
  PP.
• In a Murabahah transaction, the IIFS sells an
  asset that is already available in its
  possession, whereas in a MPO transaction the IIFS
  acquires an asset in anticipation that the asset
  will be purchased by the orderer/customer.

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II. Capital adequacy
RWA 1 Murabahah

• In Murabahah and MPO, the capital adequacy
  requirement for credit risk refers to the risk of
  a counterparty not paying the purchase price of
  an asset to the IIFS.
• In the case of market (price) risk, the capital
  adequacy requirement is with respect to assets in
  the IIFSs possession which are available for
  sale either on the basis of Murabahah or MPO and
  also on assets which are in possession due to
  cancellation of PP in non-binding and binding
  MPO.

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II. Capital adequacy
RWA 1 Murabahah

• Credit Risk
• the IIFS can secure a pledge of the sold
  asset/underlying asset or another tangible asset
  (collateralised Murabahah).
• The IIFS may employ other techniques such as
  pledge of deposits or a third party financial
  guarantee.
• the Risk Weight (RW) of collateralised Murabahah
  may be given preferential RW as set out below for
  the following types of collateralised asset
• - 75 for retail customers or working capital
  financing
• - 35 for a Murabahah contract secured by a
  residential real estate unless otherwise
  determined by the supervisory authorities or
• - 100 for a Murabahah contract secured by a
  commercial real estate or 50 in exceptional
  circumstances O.

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II. Capital adequacy
RWA 1 Murabahah

• Market Risk
• In the case of an asset in possession in a
  Murabahah transaction and an asset acquired
  specifically for resale to a customer in a
  non-binding MPO transaction, the asset would be
  treated as inventory of the IIFS and using the
  simplified approach the capital charge for such a
  market risk exposure would be 15 of the amount
  of the position (carrying value), which equates
  to a RW of 187.5

15
II. Capital adequacy
RWA 2 Salam

• A Salam contract refers to an agreement to
  purchase, at a predetermined price, a specified
  kind of commodity which is to be delivered on a
  specified future date in a specified quantity and
  quality. The IIFS as the buyer makes full payment
  of the purchase price upon execution of a Salam
  contract or within a subsequent period not
  exceeding two or three days as deemed permissible
  by its SSB.
• In certain cases, an IIFS enters into a
  back-to-back contract, namely Parallel Salam, to
  sell a commodity with the same specification as
  the purchased commodity under a Salam contract to
  a party other than the original seller. The
  Parallel Salam allows the IIFS to sell the
  commodity for future delivery at a predetermined
  price (thus hedging the price risk on the
  original Salam contract) and protects the IIFS
  from having to take delivery of the commodity and
  warehousing it.

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II. Capital adequacy
RWA 2 Salam

• Credit Risk
• The credit RW is to be applied from the date of
  the contract made between both parties until the
  maturity of the Salam contract, which is upon
  receipt of the purchased commodity.
• Based on customers rating or 100 RW for unrated
  customer.
• No netting of Salam exposures against Parallel
  Salam exposures.

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II. Capital adequacy
RWA 2 Salam

• Market Risk
• The price risk on the commodity exposure in Salam
  can be measured in two ways
• - the simplified approach
• - maturity ladder approach,
• Under the simplified approach, the capital charge
  will equal to 15 of the net position in each
  commodity, plus an additional charge equivalent
  to 3 of the gross positions, long plus short, to
  cover basis risk and forward gap risk. The 3
  capital charge is also intended to cater for
  potential losses in Parallel Salam when the
  seller in the original Salam contract fails to
  deliver and the IIFS has to purchase an
  appropriate commodity in the spot market to
  honour its obligation.

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II. Capital adequacy
RWA 2 Salam
Under the maturity ladder approach, the net
positions are entered into seven time-bands as
set out below. The net positions are entered into
seven time-bands as set out below
Time-band
0 1 month
1 3 months
3 6 months
6 12 months
1 2 years
2 3 years
Over 3 years
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II. Capital adequacy
RWA 2 Salam

• The calculation of capital charge is made in the
  following three steps
• The sum of short and long positions that are
  matched will be multiplied by the spot price for
  the commodity and then by the appropriate spread
  rate of 1.5 for each time band.
• The residual or unmatched net positions from
  nearer time bands may be carried forward to
  offset exposures in a more distant time-band,
  subject to a surcharge of 0.6 of the net
  position carried forward in respect of each
  time-band that the net position is carried
  forward.
• Any net position at the end of the carrying
  forward and offsetting will attract a capital
  charge of 15.

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II. Capital adequacy
RWA 3 Istishna

• An Istisna contract refers to an agreement to
  sell to or buy from a customer a non-existent
  asset which is to be manufactured or built
  according to the ultimate buyers specifications
  and is to be delivered on a specified future date
  at a predetermined selling price.
• The IIFS as the seller has the option to
  manufacture or build the asset on its own or to
  engage the services of a party other than the
  Istisna ultimate buyer as supplier or
  subcontractor, by entering into a Parallel
  Istisna contract
• The exposures under Istisna involve credit and
  market risks. Credit exposures arise once the
  work is billed to the customer, while market
  (price) exposures arise on unbilled
  work-in-process (WIP).

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II. Capital adequacy
RWA 3 Istishna
a) Full Recourse Istisna The receipt of the
selling price by the IIFS is dependent on the
financial strength or payment capability of the
customer for the subject matter of Istisna,
where the source of payment is derived from the
various other commercial activities of the
customer and is not solely dependent on the cash
flows from the underlying asset/project and b)
Limited and Non-recourse Istisna The receipt
of the selling price by the IIFS is dependent
partially or primarily on the amount of revenue
generated by the asset being manufactured or
constructed by selling its output or services to
contractual or potential third party buyers. This
form of Istisna faces revenue risk arising
from the assets ability to generate cash flows,
instead of the creditworthiness of the customer
or project sponsor.
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II. Capital adequacy
RWA 3 Istishna

• Credit Risk
• The receivable amount generated from selling of
  an asset based on an Istisna contract with full
  recourse to the customer (buyer) shall be
  assigned a RW based on the credit standing of the
  customer as rated by an ECAI that is approved by
  the supervisory authority. In case the buyer is
  unrated, a RW of 100 shall apply.
• For limited and non recourse Istisna . When the
  project is rated by an ECAI, the RW based on the
  credit rating of the buyer is applied to
  calculate the capital adequacy requirement.
  Otherwise, the RW shall be based on the
  Supervisory Slotting Criteria approach for
  Specialised Financing (Project Finance) as set
  out below

Supervisory Categories Strong Good Satisfactory Weak
External Credit Assessments BBB- or better BB or BB BB- to B B to C-
Risk Weights 70 90 115 250
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II. Capital adequacy
RWA 3 Istishna

• Market Risk
• a) Istisna with Parallel Istisna
• There is no capital charge for market risk to be
  applied, subject to there being no provisions in
  the Parallel Istisna contract that allow the
  seller to increase or vary its selling price to
  the IIFS, under unusual circumstances. Any
  variations in a Parallel Istisna contract that
  are reflected in the corresponding Istisna
  contract which effectively transfers the whole of
  the price risk to an Istisna customer (buyer),
  is also eligible for this treatment.
• b) Istisna without Parallel Istisna
• A capital charge of 1.6 (equivalent to a 20 RW)
  is to be applied to the balance of unbilled WIP
  inventory to cater for market risk

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II. Capital adequacy
RWA 4 Ijarah

• In an Ijarah contract (either operating or IMB),
  the IIFS as the lessor maintains its ownership in
  the leased asset whilst transferring the right to
  use the asset, or usufruct, to an enterprise as
  the lessee, for an agreed period at an agreed
  consideration.
• All liabilities and risks pertaining to the
  leased asset are to be borne by the IIFS
  including obligations to restore any impairment
  and damage to the leased asset arising from wear
  and tear and natural causes which are not due to
  the lessees misconduct or negligence.
• Thus, in both Ijarah and IMB, the risks and
  rewards remain with the lessor, except for the
  residual value risk at the term of an IMB which
  is borne by the lessee.
• The lessor is exposed to price risk on the asset
  while it is in the lessors possession prior to
  the signature of the lease contract, except where
  the asset is acquired following a binding promise
  to lease

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II. Capital adequacy
RWA 4 Ijarah

• In an IMB contract, the lessor promises to
  transfer to the lessee its ownership in the
  leased asset to the lessee at the end of the
  contract as a gift or as a sale at a specified
  consideration, provided that
• the promise is separately expressed and
  independent of the underlying Ijarah or
• a gift contract is entered into conditional upon
  fulfilment of all the Ijarah obligations, and
  thereby ownership shall be automatically
  transferred thereupon.

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II. Capital adequacy
RWA 4 Ijarah

• Credit Risk
• In a Promise to Lease (which can only be
  binding), when an IIFS is exposed to default on
  the lease orderers obligation to execute the
  lease contract, the exposure shall be measured as
  the amount of the assets total acquisition cost
  to the IIFS, less the market value of the asset
  as collateral subject to any haircut, and less
  the amount of any urbun received from the lease
  orderer.
• The applicable RW shall be based on the standing
  of the obligor as rated by an ECAI that is
  approved by the supervisory authority, and in the
  case the obligor is unrated, a RW of 100 shall
  apply.

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II. Capital adequacy
RWA 4 Ijarah

• Market Risk
• In the case of an asset acquired and held for the
  purpose of either operating Ijarah or IMB, the
  capital charge to cater for market (price) risk
  in respect of the leased asset from its
  acquisition date until its disposal can be
  categorised into the following
• (a) Non-binding Promise to Lease
• The asset for leasing will be treated as
  inventory of the IIFS and using the simplified
  approach the capital charge applicable to such a
  market risk exposure would be 15 of the amount
  of the assets market value (equivalent to a RW
  of 187.5).
• (b) Binding Promise to Lease
• In a binding PL, an IIFS is exposed to default
  on the lease orderers obligation to lease the
  asset in its possession. In the event of the
  lease orderer defaulting on its PL, the IIFS will
  either lease or dispose of the asset to a third
  party.

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II. Capital adequacy
RWA 4 Ijarah

• The IIFS will have recourse to any hamish
  jiddiyyah paid by the customer, and
• (i) may have a right to recoup from the customer
  any loss on leasing or disposing of the asset
  after taking account of the hamish jiddiyyah, or
• (ii) may have no such right, depending on the
  legal situation. In both cases, this risk is
  mitigated by the asset in possession as well as
  any hamish jiddiyyah paid by the lease orderer
  party.

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II. Capital adequacy
RWA 5 Musharakah

• A Musharakah is an agreement between the IIFS and
  a customer to contribute capital in various
  proportions to an enterprise, whether existing or
  new, or to ownership of a real estate or moveable
  asset, either on a permanent basis, or on a
  diminishing basis where the customer
  progressively buys out the share of the IIFS
  (Diminishing Musharakah).
• Profits generated by that enterprise or real
  estate/asset are shared in accordance with the
  terms of Musharakah agreement whilst losses are
  shared in proportion to the respective
  contributors share of capital party.

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II. Capital adequacy
RWA 5 Musharakah

• Three main categories of Musharakah
• Private commercial enterprise to undertake
  trading activities in foreign exchange, shares
  and/or commodities. This type of Musharakah
  exposes the IIFS to the risk of underlying
  activities, namely foreign exchange, equities or
  commodities.
• Private commercial enterprise to undertake a
  business venture (other than (1)). This type of
  Musharakah exposes the IIFS to the risk as an
  equity holder, which is similar to the risk
  assumed by a partner in venture capital or a
  joint-venture, but not to market risk. As an
  equity investor, the IIFS serves as the first
  loss position and its rights and entitlements are
  subordinated to the claims secured and unsecured
  creditors.
• Joint ownership of real estate or movable assets
  party.

31
II. Capital adequacy
RWA 5 Musharakah

• 1. Private commercial enterprise to undertake
  trading activities in the foreign exchange, share
  and/or commodity
• - The RW of a Musharakah that invests in quoted
  shares shall be measured according to the equity
  position risk approach where positions in assets
  tradable in markets will qualify for treatment as
  equity position risk in the trading book, which
  would incur a total capital charge of 16
  (equivalent to 200 RW).
• - The capital charge can be reduced to 12
  (equivalent to 150 RW) for a portfolio that is
  both liquid and well-diversified, subject to
  meeting the criteria as determined by the
  supervisory authorities

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II. Capital adequacy
RWA 5 Musharakah

• 2. Private commercial enterprise to undertake
  business venture other than trading activities in
  the foreign exchange, share and/or commodity
• Credit Risk
• Simple risk-weight method
• 400 RW of the contributed amount to the
  business venture less any specific provisions (If
  there is a third party guarantee, the RW of the
  guarantor shall be substituted for that of the
  assets for the amount of any such guarantee)
• Slotting Method

Supervisory Categories Strong Good Satisfactory Weak
Risk Weights 90 110 135 270
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II. Capital adequacy
RWA 5 Musharakah

• 3. Joint ownership of real estate or movable
  assets (Musharakah with Ijarah sub-contract,
  Musharakah with Murabahah sub-contract)
• Credit Risk
• Based on lessees (for Ijarah sub-contract) or
  customers (for Murabahah sub-contract) rating or
  100 RW for unrated lessee or customer
• Market Risk
• Refer to the market risk capital charge
  requirements as set out under the sub-contracts 2

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II. Capital adequacy
RWA 5 Mudharabah

• A Mu?arabah is an agreement between the IIFS and
  a customer whereby the IIFS would contribute
  capital to an enterprise or activity which is to
  be managed by the customer as the (labour
  provider or) Mu?arib.
• Profits generated by that enterprise or activity
  are shared in accordance with the terms of the
  Mu?arabah agreement whilst losses are to be borne
  solely by the IIFS unless the losses are due to
  the Mu?aribs misconduct, negligence or breach of
  contracted terms.
• A Mu?arabah financing can be carried out on
  either
• a) restricted basis, where the capital provider
  allows the Mu?arib to make investments subject to
  specified investment criteria or certain
  restrictions such as types of instrument, sector
  or country exposures or
• b) an unrestricted basis, where the capital
  provider allows the Mu?arib to invest funds
  freely based on the latters skills and expertise.

35
II. Capital adequacy
RWA 5 Mudharabah

• Private commercial enterprise to undertake
  trading activities in foreign exchange, shares or
  commodities
• - The RW of a Mu?arabah that invests in quoted
  shares shall be measured according to equity
  position risk approach where positions in assets
  tradable in markets will qualify for treatment as
  equity position risk in the trading book, which
  would incur a total capital charge of 16
  (equivalent to 200 RW) )
• - The capital charge can be reduced to 12
  (equivalent to 150 RW) for a portfolio that is
  both liquid and well-diversified, subject to
  meeting the criteria as determined by the
  supervisory authorities A basis, where the
  capital provider allows the Mu?arib to invest
  funds freely based on the latters skills and
  expertise.

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II. Capital adequacy
RWA 5 Mudharabah

• Private commercial enterprise to undertake a
  business venture (other than (1))
• Simple risk-weight method
• The RW shall be applied to the exposures (net of
  specific provisions) based on equity exposures in
  the banking book. The RW under the simple
  risk-weight method for equity position risk in
  respect of an equity exposure in a business
  venture shall entail a 400 for shares that are
  not publicly traded.
• However, funds invested on a Mu?arabah basis may
  be subject to withdrawal by the investor at short
  notice, and in that case may be considered as
  being as liquid as shares that are publicly
  traded. The applicable RW in such a case is 300.
  
• Slotting Method expertise.

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II. Capital adequacy
RWA 5 Mudharabah

• Mu?arabah Investment in Project Finance
• Prior to certification where funds are already
  advanced by the IIFS to the Mu?arib
• - Risk weight is based on the rating of either
  the ultimate customer or the Mu?arib
• - Otherwise, 400 RW is applied to unrated
  Mu?arib.
• After certification where amount receivable by
  the IIFS from the Mu?arib in respect of progress
  payment due to the Mu?arib from the ultimate
  customer
• - Risk weight is based on the credit standing of
  the ultimate customer on the amounts receivable
  by the IIFS from the Mu?arib
• - Otherwise, 100 RW for unrated ultimate
  customer.

38
II. Capital adequacy
RWA 6 Sukuk
Sukuk is certificates that represent the holders
proportionate ownership in an undivided part of
an underlying asset where the holder assumes all
rights and obligations to such asset ultimate
customer. Externally Rated Sukuk Applicable risk
weight will be based on the ECAI ratings in
accordance with the Standardised Approach Non
Rated Sukuk Applicable risk weight will be based
on the underlying contract or on that of the
issuer if there is recourse to the issuer
39
II. Capital adequacy
Operational risk
The proposed measurement of capital to cater for
operational risk in IIFS may be based on either
the Basic Indicator Approach or the Standardised
Approach as set out in Basel II
40
III. Risk management
The unique risk of the Islamic Banks

• Credit Risk
• Benchmark Risk
• Rate of Return Risk
• Liquidity Risk
• Operational Risk
• Legal Risk
• Withdrawal Risk
• Fiduciary Risk
• Displaced Commercial Risk

41
III. Risk management
Risk classifications

• Financial risks include
• - Market risk, the risk originating in
  instruments and assets traded in well-defined
  markets
• - Interest rate risk, the exposure of a banks
  financial conditions to movements of interest
  rate.
• - Credit risk, the risk that counterparty will
  fail to meet its obligations timely and fully in
  accordance with the agreed terms
• Non-financial risks include
• - Operational risk, the risk that arises due to
  insufficient liquidity for normal operating
  requirements reducing the ability of banks to
  meet its liabilities when it falls due.
• - Regulatory risk, the risk that arises from
  changes in regulatory framework of the country
• - Legal risk, the risk relate to risks of
  unenforceability of financial contracts

42
III. Risk management
Credit risk

• Credit risk would take the form of settlement
  /payment risk arising when one party to a deal
  pays money (e.g. in a Salam or Istishna
  contract) or delivers assets (e.g. in a Murabahah
  contract) before receiving its own assets or
  cash, thereby, exposing it to potential loss.
• In case of profit-sharing modes of financing the
  credit risk will be non-payment of the share of
  the bank by the entrepreneur when it is due
• This problem may arise for banks in the case due
  to the asymmetric information problem in which
  they do not have sufficient information on the
  actual profit in the firm.
• As Murabahah contracts are trading contracts,
  credit risk arises in the form of counterparty
  risk due to nonperformance of a trading partner.
• The non-performance can be due to external
  systematic sources

43
III. Risk management
Benchmark risk

• As Islamic banks do not deal with interest rate,
  it may appear that they do not have market risks
  arising from changes in the interest rate.
  Changes in the market interest rate, however,
  introduce some risks in the earnings of Islamic
  financial institutions.
• Financial institutions use a benchmark rate, to
  price different financial instrument.
  Specifically, in a Murabahah contract the mark-up
  is determined by adding the risk premium to the
  benchmark rate (usually the LIBOR). The nature of
  fixed income assets is such that the mark-up is
  fixed for the duration of the contract. As such
  if the benchmark rate changes, the mark-up rates
  on these fixed income contracts cannot be
  adjusted.
• As a result Islamic banks face risks arising from
  movements on market interest rate.

44
III. Risk management
Rate of return risk

• This risk is associated with overall balance
  sheet exposures where mismatches arise between
  the assets and liabilities of Islamic financial
  institutions.
• Revenue and expenses are generally accounted for
  an accrual basis when deriving the exposure and
  the Islamic financial institutions are exposed to
  the expectation of IAH when allocating their
  profits.

45
III. Risk management
Liquidity risk

• As mentioned above, liquidity risk arises from
  either difficulties in obtaining cash at
  reasonable cost from borrowings or sale of
  assets.
• The liquidity risk arising from both sources is
  critical for Islamic banks.
• As interest based loans are prohibited by
  Shariah, Islamic banks cannot borrow funds to
  meet liquidity requirement in case of need.
• Furthermore, Shariah does not allow the sale of
  debt, other than its face value.
• Thus, to raise funds by selling debt-based assets
  is not an option for Islamic financial
  institutions.

46
III. Risk management
Operational risk

• Given the newness of Islamic banks, operational
  risk in terms of person risk can be acute in
  these institutions.
• Operational risk in this respect particularly
  arises as the banks may not have enough qualified
  professionals (capacity and capability) to
  conduct the Islamic financial operations.
• Given the different nature of business the
  computer software available in the market for
  conventional banks may not be appropriate for
  Islamic banks.
• This gives rise to system risks of developing and
  using informational technologies in Islamic banks.

47
III. Risk management
Legal risk

• Given the different nature of financial
  contracts, Islamic banks face risks related to
  their documentation and enforcement.
• As there are no standard form of contracts for
  various financial instruments, Islamic banks
  prepare these according to their understanding of
  the Shariah, the local laws, and their needs and
  concerns.
• Lack of standardized contracts along with the
  fact that there are no litigations systems to
  resolve problems associated with enforceability
  of contracts by the counterparty increase the
  legal risks associated with the Islamic
  contractual agreements.

48
III. Risk management
Withdrawal risk

• A variable rate of return on saving/investments
  deposits introduces uncertainty regarding the
  real value of deposits.
• Asset preservation in terms of minimizing the
  risk of loss due to a lower rate of return may be
  an important factor in depositors withdrawal
  decisions.
• From the banks perspective, this introduces a
  withdrawal risk that is linked to the lower
  rate of return relative to other financial
  institutions.

49
III. Risk management
Fiduciary risk

• A lower rate of return than the market rate also
  introduces fiduciary risk, when
  depositors/investors interpret a low rate of
  return as breaching of investment contract or
  mismanagement of funds by the bank (AAOIFI 1999).
• Fiduciary risk can be caused by breach of
  contract by the Islamic bank.
• For example, the bank may not be able to fully
  comply with the Shariah requirements of various
  contracts.
• While, the justification for the Islamic banks
  business is compliance with the Shariah, an
  inability to do so or not doing so willfully can
  cause a serious confidence problem an deposit
  withdrawal.

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III. Risk management
Displaced commercial risk

• This risk is the transfer of the risk associated
  with deposits to equity holders.
• This arises when under commercial pressure banks
  forgo a part of profit to pay the depositors to
  prevent withdrawals due to a lower return (AAOIFI
  1999).
• Displaced commercial risk implies that the bank
  though may operate in full compliance with the
  Shariah requirements, yet may not be able to pay
  competitive rates of return as compared to its
  peer group Islamic banks and other competitors
  problem an deposit withdrawal.
• Depositors will again have the incentive to seek
  withdrawal.
• To prevent withdrawal, the owners of the bank
  will need to apportion part of their own share in
  profits to the investment depositors

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III. Risk management
A full cycle of risk management process
... It is about a perpetual improvement
continuous learning process ...
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IV. Governance
Governance

• 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.
• 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.
• Appropriate mechanism for obtaining ruling from
  sharia scholars, applying fatwa and monitor
  sharia compliance in all aspects of their
  products, operations and activities.
• Adequate and timely disclosure to IAH and the
  public of material and relevant information on
  the investment account that they manage.

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IV. Governance
Sharia governance
P 1.1 The structure should be commensurate and
proportionate with the size, complexity and
nature of its business. P 1.2 Sharia board
should have clear terms of reference, operating
procedures and reporting, and professional ethics
and conduct. P 2.1 Any person mandated with
overseeing the sharia governance fulfil the fit
and proper criteria. P 2.2 Continuous
professional development of persons serving on
its sharia board, ISCU and ISRU. P 2.3 Formal
assessment of the effectiveness of the sharia
board as a whole and of the contribution by each
member to the effectiveness of the sharia board.
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Thank you for your attention