Institute of Islamic Banking & Insurance Risk characteristics of Islamic

London 15th December 2004

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:
• articles on Islamic banking on:
dc3.co.uk/islamicbanking
• This PowerPoint is on:
dc3.co.uk/islamicfinancerisk041215.ppt
• with notes on dc3.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
• some actions can protect
• the same actions can destroy
• risk – a film

Warren Edwardes
Warren Edwardes
• 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
• 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
• 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
• 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
• 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 - 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
• 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 - 21-24
• 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 - 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 - 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 - 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 - 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 - 39-42
• 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 - 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
• 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
• 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
• 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
Risk Issues In Islamic Banking

Warren Edwardes