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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. Delphi’s website contains :.

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risk characteristics of islamic financial products
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

Warren Edwardes

delphi s website contains
Delphi’s website contains:
  • articles on Islamic banking on:dc3.co.uk/islamicbanking
  • This PowerPoint is on:dc3.co.uk/islamicfinancerisk041215.ppt
  • with notes ondc3.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

Warren Edwardes

financial risk
financial risk
  • some actions can protect
  • the same actions can destroy
  • risk – a film

Warren Edwardes

slide5
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

Warren Edwardes

a check list of 50 banking risk types
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

Warren Edwardes

banking risk types 1 4
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?

Warren Edwardes

banking risk types 5 8
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

Warren Edwardes

banking risk types 9 12
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

Warren Edwardes

banking risk types 1 3 16
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?

Warren Edwardes

banking risk types 17 20
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

Warren Edwardes

banking risk types 21 2 4
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

Warren Edwardes

banking risk types 2 5 27
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

Warren Edwardes

banking risk types 2 8 3 0
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?

Warren Edwardes

banking risk types 3 1 3 4
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?

Warren Edwardes

banking risk types 3 5 38
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

Warren Edwardes

banking risk types 39 4 2
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

Warren Edwardes

banking risk types 4 3 4 6
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?

Warren Edwardes

banking risk types 47 49
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?

Warren Edwardes

banking risk types 50
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

Warren Edwardes

particular islamic banking risk issues
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

Warren Edwardes