Managing Uncertainty in an Islamic financial institution

Presentation to the PRMIA Singapore Chapter May 2010

This document is exclusively intended for use by selected clients. Distribution, quotations and duplications even in the form of extracts for third parties is only permitted upon prior written consent of Ma Lee Advisory, Limited. Copyright 2010 Ma Lee Advisory, Limited. The text and graphs compiled in this presentation do not represent complete documentation. 2

Managing and understanding risk overcomes uncertainty

The management of risk is a process by which exposures in a financial institution are identified

measured and assessed

mitigated and controlled reported and monitored

Agenda

Brief Overview of Islamic finance Common risks faced by Islamic financial institutions and their financial instruments. Specific risks of Shari'ah compliant banking products Reducing risk in Islamic financial institutions

Background

Islamic financial institutions (IFI) are operating in over 75 countries, managing between $500 billion and $1 trillion assets Islam prohibits dealing in interest as well as any investment in liquor, swine/pork products, gambling, pornography and anything else, which the SharIah deem unlawful Islamic financial system employs the concept of participation in the enterprise, utilizing the funds at risk on a profit-and- loss-sharing basis Islamic banking, with 15 to 20% growth a year, has emerged as one of the vital pillars of the global economic system Increasing linkages between OIC financial centers such as Kuala Lumpur, Dubai and Bahrain Significant interest in Islamic finance being shown by countries such as UK, France, Australia, Singapore, Hong Kong, China and Japan

Focus : Islamic Finance News (Reuters)

Significant insight into real-time Islamic events

Source: ThompsonReuters

What is an Islamic financial institution

Financing

Investment

Money Market

Islamic Financial Institution

Shareholder

Depositor

Features of Islamic banking

Interest (riba)-free - money is only a medium for exchange; one can not earn more money by itself without putting it real productive, action Uncertainty or lack of knowledge (gharar)-free must avoid all disputes due to unfairness in dealings due to lack of knowledge Gambling (maysir)-free - transfers of wealth, not the creation of new wealth Not involved in something impure or not halal - religious and ethical value considerations

Not in direct conflict with established Shariah principles in muamalah

Focus : Islamic Glossary (Reuters)

A glossary for clarifying even the most esoteric products

Source: ThompsonReuters

Recent market events

Repatriation of dollars by Arab investors Liquidity due to oil revenues Sukuk defaults Dubai under crisis Regulatory Activity

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Focus : Crisis & Islamic Finance [ISLF] (Reuters)

Up to date news on the latest industry developments

Source: ThompsonReuters

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Sovereign and agency debt issuance

Dubai: $1 billion Qatar: $700 million Pakistan: $600 million Malaysia: $600 million German State of Saxony-Anhalt: 100 million

Bahrain: $79.5 million

Islamic Development Bank: $400 million World Bank: $200 million

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Focus : Malaysian Sukuk (Reuters)

Everything you need to know about Sukuks

Source: ThompsonReuters

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Corporate debt issuance

DP World: 3.5 billion 7.5% Sukuk, convertible into equity at the time of a qualifying initial public offering National Central Cooling Company: $200 million, rated BBB- by S&P

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Focus : DP World Sukuk Limited (Reuters)

Deep dive into specific issuances

Source: ThompsonReuters

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Focus : Terms and Conditions (Reuters)

and deeper

Source: ThompsonReuters

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Recent Singapore Developments

Singapore is encouraging the growth of Islamic finance and recently announced its intention to become a hub of Islamic finance Beginning in 2005, banks in Singapore were allowed to offer Murabaha financing The Development Bank of Singapore (DBS) recently established the Islamic Bank of Asia, to focus on wealth management and capital market instruments for corporate and private banking clients in the Middle East and Asia There is a governmental initiative to achieve tax equality between approved Islamic products and conventional financing arrangements Singapore is moving quickly to remove the double stamp duty hit on Murabaha and Ijara contracts Tax incentives granted to qualifying debt securities extended to approved Islamic bonds

No stamp duty on the transfer of asset to SPV set up for Islamic Financing purposes

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Focus : Islamic Scene in Singapore (Reuters)

And of course a great source of local information

Source: ThompsonReuters

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Conventional international banks with Islamic activities

Citigroup HSBC Deutsche Bank UBS ABN AMRO

Standard Chartered Bank

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Focus : HSBC Islamic (Reuters)

Deep dive into a financial institutions activities

Source: ThompsonReuters

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Agenda

Brief Overview of Islamic finance Common risks faced by Islamic financial institutions and their financial instruments. Specific risks of Shari'ah compliant banking products Reducing risk in Islamic financial institutions

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Does Islamic banking risk differ from Conventional banking risk?

Islamic Banking is ALL about who bears risk Trade credit ?

Asset backed secured or unsecured ?

Debt or equity ? Leasing ? Repos / Murabahah ?

Fund management ?

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Risk profile of Islamic financial institutions

100%

80%

60%

40%

20%

0%

ija ra

sa la m

ha h

a'

ud ha ra ba h

us ha ra ka h

ur ab a

is tis n

Credit Risk

Market Risk

Liquidity Risk

Operational Risk
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D.

us ha

ra ka

 unique risks in an Islamic financial institution

Rate of return risk Shariah risk Equity investment or position risk Risk transformation Unrealistic funding costs

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Focus : Risk Islamic (Reuters)

Ability to search on key words, like risk management activities

Source: ThompsonReuters

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Rate of return risk

Associated with the management of assets and liabilities Fixed rate long term assets funded by variable rate short-term liabilities Movement in benchmark rates may result in fund providers having expectations of a higher rate of return Subsequently, it may result in displaced commercial risk where due to market pressure, Islamic bank needs to pay a return that exceeds the rate that has been earned on its assets.

If Islamic bank does not yield to market pressure, they may lose their fund providers which could consequently lead to liquidity risk

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Shariah risk

Limited available talent pool, especially for positions on the Shariah board It takes many years of education and practical experience to become a Shariah scholar Different Shariah boards even within the same country may deliver different interpretations

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Agenda

Brief Overview of Islamic finance Common risks faced by Islamic financial institutions and their financial instruments. Specific risks of Shari'ah compliant banking products Reducing risk in Islamic financial institutions

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Unique Credit Risks

Refusing to honor the promise to buy a Murabaha contract Refusing to honor the specific aspects of a Salam contract Declining to honor the promise to accept the delivery agreement of a Istisna contracts Non-compliance with the leasing structure of Ijara contracts

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Focus : More Islamic Risk Insights (Reuters)

Marketplace trends on Islamic finance

Source: ThompsonReuters

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Other risks may arise from various sources

Limited secondary trading market for Sukuk Directly expose to commodity price risk because Islamic banks carry inventory items Non-standardized nature of some Islamic products The lack of an efficient and reliable Shariah legislation system to enforce financial contracts Lack of risk-hedging instruments due to the prohibition against riba and some fiqh issues in the interpretation of gharar mean that many risk hedging instruments based on traditional tools, such as option, futures and forwards are not available to Islamic banks Underdeveloped money market and government securities based on profit loss sharing

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Islamic banks have ineffective liquidity management

Islamic banks tend to have a concentrated base of deposits and assets. Islamic banks have been forced to hold a large proportion of their assets in reserve accounts in central banks or in correspondent accounts than conventional banks Islamic banks face underdeveloped or nonexistent money markets

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Studies have also identified weaknesses and vulnerabilities in the areas of risk management and governance

The failure of systems, processes, and procedures, is one area of concern The existence of weak internal control processes The quality of management, technical expertise, and professionalism, is also an issue

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Then there is

A lack of good risk management professionals in the Islamic financial institution Risk management Is not seen as a core competency Education of the Boards is lacking on capital adequacy and risk mitigation

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Agenda

Brief Overview of Islamic finance Common risks faced by Islamic financial institutions and their financial instruments. Specific risks of Shari'ah compliant banking products Reducing risk in Islamic financial institutions

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Essentially an integrated approach to risk management, governance and compliance

Governance
Determining Objectives and Knowing We Are Executing Appropriately

Enterprise Risk Management

Identifying Risks That May Affect Our Ability to Achieve Objectives And Determining How to Respond

Compliance
Executing as Expected To Support Achievement of All Objectives

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Management, the Board, and the regulators each have a role to play in ensuring that risk is managed effectively

Management level
The quality of strategic and operational monitoring and management

Board level
The quality of questions being asked about the performance of the financial institution under the worst-possible-stress scenarios

Regulatory level
The quality of published regulatory requirements, so far these have lack any quantitative criteria or guidelines

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Both the Board and management should ask questions

Do you feel your organization is taking the appropriate level of risk? Do you know what the risks are for the organization you are supporting? Does management agree on the importance of these risks? Does management know the real level of impact and likelihood for these risks? For risks that are undermanaged, does your organization have a plan in place to improve the management of these risks? For risks that are over managed, does your organization have a plan in place to improve the management of these risks? Does your organization take inconsistent levels of risks?

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The Board must take responsibility for defining capacity, appetite and limits
Capacity represents the maximum amount of risk that can be supported Risk Capacity is determined by considering the following: Availability of capital resources Ability to raise capital (access to capital markets) Earnings strength and stability - growth in capital over the planning horizon

Capacity

Appetite

Risk Appetite serves as an overall guide to resource and capital allocation Business strategy must be aligned with risk appetite

Risk Appetite should be allocated to individual risk types, businesses based upon capital requirements relative to potential returns and risk concentrations Limits should effectively control risks within the context of the overall risk appetite Limits should reflect enterprise Risk Preferences and align to support strategic plans and capital allocation Limits should be set at a level which may be periodically tested (i.e., limits should be established at levels that may be exceeded at times)

Limits

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Management must measure risk and provide frameworks to effectively control risk taking

A robust liquidity risk management framework and governance process Gap analysis for a timeframe in which meaningful actions can be taken or one far enough forward that underlying information can be relied upon with a significant degree of certainty Detailed understanding (nature and purpose) of assets held and liabilities, contingent obligations, the reliability of credit availability, and the potential market reaction to actions considered to be taken the in response to market behaviors Implement information systems

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The Islamic financial institution should align business strategy to risk tolerance

How much on balance sheet exposure is allowed What is the proportion of total reliable liquidity What is the maximum refinancing requirement during a period (day, week, etc) What concentration is allowed by Any one provider

Any one product

What is the target surplus based on expected or worst case probabilities?

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Challenges in Islamic finance

Organization and resource issues Liquidity management constraints Currency risk and volatility Repatriation issues Regulation constantly changing

Information and data restraints

Internal control issues Shariah compliance is crucial

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Question & Answer

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About Ma Lee Advisory, Limited

Ma Lee is a boutique Asian advisory firm, focused on client service through a sound strategy of producing and implementing results. The firm delivers solutions in three professional areas, Strategy, Risk Management, and Corporate Finance, with the support of seasoned subject matter experts with over 20 years of exceptional, practical experience in industry, Big-4 accounting firms, and consultancies. Since inception, three years ago, Ma Lee has been advising some of the largest financial institutions across Asia, from our home office in Hong Kong. Project delivery occurs on the Chinese mainland, Korea, Malaysia, Singapore, as well as within the GCC.

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