operational risk management in islamic banks : new research findings
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© 2013 Nasreen Al Qaseer
Operational Risk Managementin Islamic Banks:
New Research Findings
Session 9 Presentation by Dr. Nasreen Al Qaseer, GM – Risk Management Kuwait International Bank
© 2013 Nasreen Al Qaseer
Investing in Operational Risk ManagementMost Banks are investing to manage Operational Risks based on:• Best fits for their individual objectives• Circumstances and Management views• Practice
Banks are trying to find the right balance between Risk Measurement and Risk Management
© 2013 Nasreen Al Qaseer
Traditional and Modern ORMTwo general approaches for managing Operational Risk:1) Traditional• Related to an imminent threat• Requires tactical decisions and solution• May not address strategic issues such as
optimizing the Risk / Control relationship in the context of risk / loss tolerance
2) Modern• Designed to help make strategic decisions• Requires different framework
based on data models and scenario analysis
© 2013 Nasreen Al Qaseer
Diversity and Common Approach – Key FindingsDiversity is caused by• Choices and circumstances• Regulatory influence• Early stage in evaluation of
risk managementCommon Approaches – Building Blocks• Good Governance enabling scenario analysis• Preparing and designing scenarios with clear
objectives• Assessment by subject matter experts, business
unit managers, executives, risk managers, etc.• Validation of results• Reporting
© 2013 Nasreen Al Qaseer
Problems with Traditional MethodsIn most banks, the ORM framework is based on traditional risk and control self assessments (RCSA)• High Risk is often assessed as High Likelihood and
High Impact rather than Low Frequency and High Severity
• Focus on high operational issues rather than operational risk
• May result in excessive controls in areas where there is most risk
• Managing operations differs from managing risks
• Limits potential failures to one possible outcome, whereas in fact they can have wide range of outcomes
© 2013 Nasreen Al Qaseer
Modern Approach to ORMModern ORM framework is based on• Historical Data and Actual Loss Models• Loss Frequency and Severity distribution of
expected and unexpected losses• A multi-dimensional framework • Helps determining the nature of businesses to
invest in, based on their risk-reward relationship• Helps determining which risk mitigation strategies
to employ by optimizing the risk/reward and risk/control relationship across the full spectrum of exposures.
© 2013 Nasreen Al Qaseer
The Problem with Loss Data• Analyzing internal loss data merely depicts the status
of a bank’s control environment.• To model and anticipate risks, scenarios should be
employed, preferably with the frequency and severity input of reliable external data.
• Such data are hard to come by from public sources.• Ideally, banks would share their losses anonymously in
a loss data consortium, as is already being done by conventional banks in various countries, such as the UK, the US, Italy, Germany, Korea, Japan, Kazakhstan, or Indonesia.
• There is interest for such consortia in several Gulf states, but without the local regulator’s public encouragement, the efforts keep ending up as failed initiatives.
© 2013 Nasreen Al Qaseer
Risk Management in Islamic BanksIslamic Banks face lower levels of Risk than Conventional Banks due to the following:• The returns on saving/investment deposits are
contingent. As depositors are rewarded on a profit/loss sharing basis, they share also the business and credit risks of the bank’s operations.
• The use of Islamic financing models on the asset side changes the nature of traditional risks.
• Credit risk arises in the form of counterparty risk due to non-performance of a trading partner.
• Non-payment of dues in the stipulated time by the counterparty implies a loss to bank.
• Market risk incurred in instruments like commodities and equities traded in well-traded markets appears to be lower.
© 2013 Nasreen Al Qaseer
Operational Risk Challenges in Islamic Banks -1Operational risk can arise from different sources:• Some aspects relevant to operational risk in Islamic
banks are the legal risk involved in contracts, the understanding of the modes of financing by employees, producing computer programs and legal documents for different instruments, etc.
• Operational risk is lowest in fixed income assets, and highest in product-deferred sale contracts.
• As the rates of returns on deposits in Islamic banks are based on profit sharing, this implies certain risks on the liability side of the balance sheet. Even though returns on deposits can vary, Islamic banks are under pressure to give the depositors a return similar to that of conventional banks. Depositors typically blame the bank for a lower rate of return.
© 2013 Nasreen Al Qaseer
Operational Risk Challenges in Islamic Banks -2Other sources for operational risk include:• Islamic financial institutions have also identified
other risks that they face. At the government level, these include legal, central bank regulations and legislation, no Islamic window for borrowing in terms of need, non-availability of short-term funds foreign exchange, natural disasters, specific industries, domestic economy and politics, and international financial and market environment.
• Not to be neglected is the KYC principle. Islamic banks must not do business with customers who turn to Shariaa non-compliant activities. Ongoing KYC is therefore much more important than with conventional banking.
© 2013 Nasreen Al Qaseer
Boundary Risk Challenges in Islamic Banks• Operational misbehavior or misguided strategies of
the bank may result in reputational harm. And in Islamic finance, a bank’s reputation is much more critical to attract investors than in conventional banking. Any Islamic bank with consistent negative headlines like currently JPMorgan, RBS, Barclays or UBS would probably long be out of business.
• Similar to other banking types, operational risk is a major part of a bank’s credit portfolio. In my thesis I found that about 60% of underlying reasons for loan defaults were operational in nature, 10% were market risk driven, and only 30% of underlying default reasons were truly credit risk.
© 2013 Nasreen Al Qaseer
Assessment of Operational Risk in Islamic Banks -1One of the highest traditional risks for banks is Operational Risk, but it is hardly ever recognized with its inherent importance.As per the overall assessment of Risk Management Systems in Islamic Banks, the following aspects appear to have been reasonably addressed• Establishing an Appropriate Risk Management
Environment, Policies, and Procedures• Maintaining an Appropriate Risk Measuring,
Mitigation, and Monitoring Process • Policies and Safety nets introduced by regulatory
authorities to protect the integrity of markets, to safeguard the interests of depositors and to avoid systemic risks.
© 2013 Nasreen Al Qaseer
Assessment of Operational Risk in Islamic Banks -2• Ensuring the maintenance of a minimum level of
risk-based capital• Putting in place an effective system of risk-based
supervision and ensuring the timely disclosure of correct information about risk management systems and processes
• Risk Disclosure: Providing transparency to stakeholders
• Relevance of the International Standards for Islamic Banks: The Core Principles document sets pre-conditions for effective banking supervision
• The difficulty in applying international standards for Islamic banks lies in applying uniform capital adequacy standards.
© 2013 Nasreen Al Qaseer
Some Other Shariaa Related IssuesMurabaha, Shariaa Operational Risk related
issues:• Type of transactions• Sequence of owning the financed “goods”,
Bank owns first, then the client• The existence of the “goods” and to check its
specifications, and extent of the financial impact of the transactions on the Bank’s profits
Tawaruq , Shariaa Operational Risk related issues:
• 3rd party is really involved in the deal by selling or buying
• Wording and attachments of the contract
© 2013 Nasreen Al Qaseer
Presented by Dr. Nasreen Al Qaseernalqaseer@gmail.com
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