Risk Management and Corporate Governance in Islamic Financial Institutions

  

RISK MANAGEMENT AND

RISK MANAGEMENT AND

CORPORATE GOVERNANCE IN

CORPORATE GOVERNANCE IN

  

ISLAMIC FINANCIAL

  

ISLAMIC FINANCIAL

  

INSTITUTIONS

  

INSTITUTIONS

ZULKIFLI HASAN

ZULKIFLI HASAN

HAWKAMAH, THE INSTITUTE OF CORPORATE GOVERNANCE

  

HAWKAMAH, THE INSTITUTE OF CORPORATE GOVERNANCE

  26

  26 ^{TH TH} MARCH 2009 MARCH 2009

  

CONTENTS



CONTENTS

Introduction Introduction

  

  

  

  

Risk Management in IFIs Risk Management in IFIs

  

Roles of Board of Directors (BOD) and Senior Roles of Board of Directors (BOD) and Senior Management Management

  

  

Case Study: Closure of Ihlas Finance, due to Poor Case Study: Closure of Ihlas Finance, due to Poor Corporate governance (CG) Corporate governance (CG)

What is CG? What is CG?

Why it is important to Islamic risk management Why it is important to Islamic risk management system? system?

Elements of Good CG in IFIs Elements of Good CG in IFIs

Roles of Shari’ah Board Roles of Shari’ah Board

  

  Concluding Remarks Concluding Remarks

  

Financial Distress and Failure of Ihlas Finans

Financial Distress and Failure of Ihlas Finans

  

Financial Crisis in Turkey 2000-2001.

  

Financial Crisis in Turkey 2000-2001.

  One Islamic institution Ihlas Finans One Islamic institution Ihlas Finans

  

(the frst domestic IFI in Turkey) was

(the frst domestic IFI in Turkey) was

closed during the crisis while the other closed during the crisis while the other fve Islamic bsanks were survived. fve Islamic bsanks were survived.

   Ihlas Finans is a special fnance house

  Ihlas Finans is a special fnance house estabslished in 1995 and was a estabslished in 1995 and was a subssidiary of Ihlas Holdings. subssidiary of Ihlas Holdings.

   The BRSA cancelled the license of

  The BRSA cancelled the license of Ihlas Finans on 10

  Ihlas Finans on 10

th

th

Febsruary 2001.

  Febsruary 2001.

Factors Factors

   Accumulation of bsad debst

  Accumulation of bsad debst

• Politically motivated
• Politically motivated

  

lending and lending to connected bsusiness. Finance

lending and lending to connected bsusiness. Finance

the bsusinesses of its parent company, Ihlas Holdings. the bsusinesses of its parent company, Ihlas Holdings.

   Lax Regulation-

  Lax Regulation- Law on full guarantee of the bsank

  Law on full guarantee of the bsank deposits ofered bsy the State made bsanking a deposits ofered bsy the State made bsanking a lucrative bsusiness for the corrupt entrepreneurs with lucrative bsusiness for the corrupt entrepreneurs with political connections who set up bsanks that siphoned political connections who set up bsanks that siphoned of money. of money.

   Major proportion of the investment was an illiquid

  Major proportion of the investment was an illiquid assets assets and projects as compared to other domestic and projects as compared to other domestic

and foreign commercial bsanks who could hold very

and foreign commercial bsanks who could hold very

liquid government securities. liquid government securities.

   Failures in CG and lack of internal checks and

  Failures in CG and lack of internal checks and bsalances bsalances

  :- Control failure, Management failure and :- Control failure, Management failure and regulatory failure. regulatory failure.

What is CG? What is CG?

  

CG is the system by which business corporations are CG is the system by which business corporations are directed and controlled . directed and controlled

  

CG specifies the distribution of rights and CG specifies the distribution of rights and responsibilities among different participants in the responsibilities among different participants in the company such as BOD, Shari’ah board, managers, company such as BOD, Shari’ah board, managers, shareholders, and other stakeholders. shareholders, and other stakeholders

  

A concept of CG in IFIs presents distinct A concept of CG in IFIs presents distinct characteristics and features in comparison with the characteristics and features in comparison with the conventional system as it goes beyond the financial conventional system as it goes beyond the financial return whereby it covers the element of ethic, return whereby it covers the element of ethic, Shari’ah and beliefs (aqidah). Shari’ah and beliefs (aqidah)

  

  Shari’ah board plays significant role to supervise , Shari’ah board plays significant role to supervise , oversea and advise the shari’ah aspects of the oversea and advise the shari’ah aspects of the corporation. corporation.

  Why CG is important for risk Why CG is important for risk

management in IFIs?

management in IFIs?

  

Hypothesis 1: Weak CG may lead to Hypothesis 1: Weak CG may lead to inefective risk management system. inefective risk management system

  

Hypothesis 2: Strong commitment to Hypothesis 2: Strong commitment to good CG will improve and strengthen good CG will improve and strengthen risk management system in IFIs risk management system in IFIs

  

  Case Study: Ihlas Finans was closed Case Study: Ihlas Finans was closed in 2001 due to poor CG while the in 2001 due to poor CG while the other fve Islamic banks in Turkey other fve Islamic banks in Turkey were survived because of better CG. were survived because of better CG.

  

Existing Studies

Existing Studies

   Well governed UK companies posted 18% higher

  Well governed UK companies posted 18% higher returns than those with poor governance after returns than those with poor governance after

adjusting for risk (ABI Research Paper 7: 2008);

adjusting for risk (ABI Research Paper 7: 2008);

   Well governed frms in Korea have bseen found to

  Well governed frms in Korea have bseen found to

trade at a premium of 160% to poorly governed

trade at a premium of 160% to poorly governed

frms (Black, B lt al: 20040); frms (Black, B lt al: 20040);

   A study of S&P 500 frms showed that companies

  A study of S&P 500 frms showed that companies with strong or improving CG practices with strong or improving CG practices

outperformed those with poor or deteriorating

outperformed those with poor or deteriorating governance practices bsy absout 19% over a 2- governance practices bsy absout 19% over a 2- year period (Grandmont, R lt al: 20040). year period (Grandmont, R lt al: 20040).

   A worst-to-bsest improvement in CG predicted an

  A worst-to-bsest improvement in CG predicted an astronomical 700-fold increase in frm value astronomical 700-fold increase in frm value among Russian frms (Black, B: 2001). among Russian frms (Black, B: 2001).

  

The Six Elements of Good CG in

The Six Elements of Good CG in

  

IFIs

  IFIs

  

Risk Management in IFIs

Risk Management in IFIs

   Certain types of risks are of equal concern

  Certain types of risks are of equal concern

to all fnancial institutions, including IFIs.

to all fnancial institutions, including IFIs.

  

  IFIs face additional risks that emanate

  IFIs face additional risks that emanate from the unique characteristics of Islamic from the unique characteristics of Islamic fnance transactions, along with risks fnance transactions, along with risks

associated with the real or perceived non-

associated with the real or perceived non-

compliance of Shariah principles. compliance of Shariah principles.

  

The survival and success of IFIs depends

  

The survival and success of IFIs depends

on the eficiency in which they can on the eficiency in which they can manage its risks and how they will manage its risks and how they will

manage diferent risks arising from their

manage diferent risks arising from their

operations. operations.

  

How good CG may improve Risk

How good CG may improve Risk

Management System? Management System?

  

IFIs shall have in place a comprehensive risk management and comprehensive risk management and reporting process, including reporting process, including appropriate board and senior appropriate board and senior management oversight management oversight , to identify, , to identify, measure, monitor, report and control measure, monitor, report and control relevant categories of risks and, where relevant categories of risks and, where appropriate, to hold adequate capital appropriate, to hold adequate capital against these risks. against these risks

IFIs shall have in place a

  

The process shall take into account The process shall take into account appropriate steps appropriate steps to comply with to comply with

  Sharī`ah Sharī`ah

  rules rules and principles and to and principles and to ensure the adequacy of relevant risk ensure the adequacy of relevant risk reporting to the supervisory authority.

  

Risk Management in IFIs

Risk Management in IFIs

  

Roles of Board and Senior

Roles of Board and Senior

  

Management

Management

   Approve the risk Approve the risk management objectives, management objectives, strategies, policies and procedures strategies, policies and procedures ; ;

   Ensure the existence of Ensure the existence of an efective risk an efective risk management structure management structure for conducting IFIs’ for conducting IFIs’

activities, including adequate systems for

activities, including adequate systems for

measuring, monitoring, reporting and measuring, monitoring, reporting and controlling risk exposures; controlling risk exposures;

  

  IFIs shall have in place

  IFIs shall have in place an appropriate an appropriate

body, in accordance with sound principles

body, in accordance with sound principles

of CG of CG , to oversee that all products and , to oversee that all products and activities comply with activities comply with

  Sharī`ah Sharī`ah rules and rules and

principles as approved in each jurisdiction

principles as approved in each jurisdiction

.

  .

Cont…

Cont…

   Approve

  Approve limits on aggregate fnancing and limits on aggregate fnancing and investment exposures investment exposures to avoid concentration to avoid concentration

of risk and, ensure that IFIs hold adequate

of risk and, ensure that IFIs hold adequate capital against these exposures. capital against these exposures.

   Review the efectiveness of the risk Review the efectiveness of the risk management management activities periodically and make activities periodically and make

appropriate changes as and when necessary.

appropriate changes as and when necessary.

   Execute the strategic direction Execute the strategic direction set by the set by the

BOD on an ongoing basis and set clear lines

  

BOD on an ongoing basis and set clear lines

of authority and responsibility; of authority and responsibility;

   Senior management shall ensure that the Senior management shall ensure that the risk management function is risk management function is independent independent from the risk-taking activities from the risk-taking activities and is and is reporting directly to the BOD or senior reporting directly to the BOD or senior management outside the risk-taking unit. management outside the risk-taking unit.

  Types of Risk Roles of BOD and Senior Management

Credit Risk Strategy for fnancing and recognize the potential

^• credit exposures. ^• Carry out due diligence review ^• Appropriate methodologies for measuring and reporting credit risk exposure

• ^• Shariah-compliant credit risk mitigating techniques ^•

  Equity Strategy for risk characteristics of equity Investment investments

• ^• Risk Appropriate valuation methodologies Establish exit strategies in respect of equity ^• investment activities ^•

  Market Risk Appropriate framework for market risk management in respect of all assets held

• ^• Liquidity Appropriate liquidity management framework ^• Risk Able to assume that liquidity risk commensurate with their ability to have suficient recourse to Shariah-compliant funds to mitigate such risks ^•

  Rate of Comprehensive risk management and reporting Return Risk process to assess the potential impacts of market factors afecting rates of returns on assets in comparison with the expected returns for IAH

• ^• Operational Adequate system and controls to ensure Shariah Risk compliance

  

Roles of Shari’ah Board

Roles of Shari’ah Board

  

  IFIs shall have adequate system of controls

  IFIs shall have adequate system of controls including Shari’ah governance (SG) system.

including Shari’ah governance (SG) system.

   SG is a set of institutional and

  SG is a set of institutional and organizational arrangements through which organizational arrangements through which

  IFIs ensure that there is independent

  IFIs ensure that there is independent oversight of Shari’ah compliance. oversight of Shari’ah compliance.

  

  IFIs shall have in place a Shari’ah bsoard

  IFIs shall have in place a Shari’ah bsoard (SB) to review and ensure that all fnancing

  (SB) to review and ensure that all fnancing proposals are Shari’ah compliant at all proposals are Shari’ah compliant at all times. times.

   Internal/lxternal Shari’ah review unit to

  Internal/lxternal Shari’ah review unit to assist the SB for Shari’ah-compliance assist the SB for Shari’ah-compliance purpose. purpose.

  

How Shari’ah governance

How Shari’ah governance

complements the existing

complements the existing

corporate governance?

corporate governance?

  

Shari’ah Non-Compliance Risk

Shari’ah Non-Compliance Risk

  IFIs shall at all times comply with the Shari’ah comply with the Shari’ah rules and principles as determined bsy the SB rules and principles as determined bsy the SB with respect to products, activities and contract with respect to products, activities and contract documentation. documentation.

  IFIs shall

  

  .

  IFIs shall undertake a Shari’ah compliance undertake a Shari’ah compliance review review .

  IFIs shall

  

  IFIs shall at all times

  

  

  These risk exposes IFIs to fund providers’ withdrawals, loss of income or voiding contracts withdrawals, loss of income or voiding contracts leading to a diminished reputation or the leading to a diminished reputation or the limitation of bsusiness opportunities. limitation of bsusiness opportunities.

   These risk exposes IFIs to fund providers’

  .

  Shari’ah non- compliance risks compliance risks and also and also to reputational risk to reputational risk .

  IFIs are exposed to risk relating to Shari’ah non-

  IFIs are exposed to risk relating to

  IFIs shall keep track of income not recognized keep track of income not recognized arising out of Shari’ah non-compliance. arising out of Shari’ah non-compliance.

Some Impact of Shari’ah Non-

Some Impact of Shari’ah Non-

Compliance Risk Compliance Risk

   Slowdown of globsal Sukuk issuance.

  Slowdown of globsal Sukuk issuance.

  

By the end of 2008, globsal Sukuk issuance had

  

By the end of 2008, globsal Sukuk issuance had

declined bsy more than 50% compared to 2007. declined bsy more than 50% compared to 2007.

   Chairman of the AAOIFI Shari’ah bsoard-

  Chairman of the AAOIFI Shari’ah bsoard- criticized a common form of sukuk that criticized a common form of sukuk that apparently violates the Sharia-compliant apparently violates the Sharia-compliant

principles surrounding risk and proft-sharing.

principles surrounding risk and proft-sharing.

  He estimated that up to 85% of Gulf Sukuk He estimated that up to 85% of Gulf Sukuk structures were not Shari’ah-compliant. structures were not Shari’ah-compliant.

   AAOIFI made a recommendation to Islamic

  AAOIFI made a recommendation to Islamic fnance market participants to refrain from fnance market participants to refrain from

issuing Sukuk structures that have a purchase

issuing Sukuk structures that have a purchase

undertaking or guarantee from the Sukuk issuer undertaking or guarantee from the Sukuk issuer to repurchase at a future date at a specifc price. to repurchase at a future date at a specifc price.

  

Elements of Good Shari’ah Board

Elements of Good Shari’ah Board

  

Concluding Remarks

Concluding Remarks

   Good CG is crucial in providing efective risk Good CG is crucial in providing efective risk management system. management system.

   Certain types of risks are of equal concern to all Certain types of risks are of equal concern to all institutions ofering fnancial services, but there institutions ofering fnancial services, but there

are certain specifc risks which are exclusive to

are certain specifc risks which are exclusive to

IFIs.

  IFIs.

   Board of Directors and Senior management have Board of Directors and Senior management have specifc roles in relation to specifc roles in relation to risk management risk management objectives, strategies, policies and procedures in objectives, strategies, policies and procedures in order to mitigate all types of risks. order to mitigate all types of risks.

   Shari’ah board is more concerned on the aspect

  

Shari’ah board is more concerned on the aspect

of Shari’ah non-compliance and reputational of Shari’ah non-compliance and reputational risks. risks.

  

  IFIs need for a set of best practices of corporate

  IFIs need for a set of best practices of corporate governance and efective risk Management that

governance and efective risk Management that

give practical efect to managing the underlying give practical efect to managing the underlying risks. risks.

  

References

_

_{from Closure of Ihlas Finans in Turkey , Islamic Economic Studies, Vol.}

_{Ali, Salman Syed (2007). Ali, Salman Syed (2007). Financial Distress and Bank Failure: Lessons Financial Distress and Bank Failure: Lessons}

References

_{ ABI Research Paper 7. (February 2008). Governance and Performance in ABI Research Paper 7. (February 2008). Governance and Performance in 14, No. 1 & 2, Aug. 2006 & Jan. 2007, pp: 1-52. 14, No. 1 & 2, Aug. 2006 & Jan. 2007, pp: 1-52.}

from Closure of Ihlas Finans in Turkey , Islamic Economic Studies, Vol.

_{ Evidence From Korea. University of Texas Law School Working Paper No. Black, B. S. Jang, H and Kim, W (2004). Predicting Firms CG Choices:} Corporate Britain Corporate Britain . London: The Association of British Insurers. . London: The Association of British Insurers. _{Evidence From Korea. University of Texas Law School Working Paper No.}

_{Black, B. S. Jang, H and Kim, W (2004). Predicting Firms CG Choices:}

_{ Emerging Market Review, Vol. 2, March. Emerging Market Review, Vol. 2, March.}

_{Black, B. (2001). The CG Behavior and Market Value of Russian Firms .}

_{Black, B. (2001). The CG Behavior and Market Value of Russian Firms .}

39, August. 39, August. _  _{Hijazi, Faisal. (2009). Global Sukuk Issuance: 2008 Slowdown Mainly Due Implications for Investors Implications for Investors , (Deutsche Bank, April 1). , (Deutsche Bank, April 1).}

_{Grandmont, R, Grant, G. and Silva, F. (2004). Beyond the Numbers- CG:}

_{Hijazi, Faisal. (2009). Global Sukuk Issuance: 2008 Slowdown Mainly Due}

_{Grandmont, R, Grant, G. and Silva, F. (2004). Beyond the Numbers- CG:}

_{ to Credit Crisis and Some Impact on Shari’ah compliance issues. IFC and Hawkamah. (2008). A Corporate Governance Survey of Listed IFC and Hawkamah. (2008). A Corporate Governance Survey of Listed International Structured Finance Special Report. International Structured Finance Special Report.} to Credit Crisis and Some Impact on Shari’ah compliance issues. _

_{IFSB Exposure Draft Guiding Principles on Shari’ah Governance System.}

_{Washington: IFC. Companies and Banks Across the Middle East & North Africa .} Companies and Banks Across the Middle East & North Africa .

_{IFSB Exposure Draft Guiding Principles on Shari’ah Governance System.}

_{Washington: IFC.}

   _{then Insurance Institutions) Ofering Only Islamic Financial Services. then Insurance Institutions) Ofering Only Islamic Financial Services. IFSB Guiding Principles of Risk Management For Institutions (Other IFSB Guiding Principles of Risk Management For Institutions (Other}

  Thank You Thank You Zulkifi Hasan Zulkifi Hasan

E-mail: zul361977@yahoo.com

  E-mail:

  Blog: Blog:

http://zulkifihasan.wordpress.com

http://zulkifihasan.wordpress.com

  Tel: +44 (0) 7761457686 Tel: +44 (0) 7761457686