Risky business

The sharia-compliant finance industry needs to improve the way it manages risk. Published in The Gulf, August 2013

When the crisis hit the global banking industry in 2008, many of the world’s largest and most respected banks stumbled and fell. One corner of the industry, however, seemed to avoid the contagion, at least at first.

Islamic finance appeared to offer a safer alternative to the conventional industry, given its different approach to risk. There were no derivatives on the books of Islamic banks to worry about and no mortgage-backed securities either. Given the fact that sharia-compliant institutions would only lend money to their customers on the basis of physical assets, rather than notional ones, and that any risk was always shared between the borrower and their bank, it seemed to be an inherently more secure system.

Yet since then the confidence in the Islamic banking model has been gradually eroding and problems have emerged in many of the Gulf markets, both at the banks themselves and at companies using Islamic finance products. The first significant problems emerged in Kuwait when The Investment Dar defaulted on a $100 million Islamic bond (sukuk) in May 2009. Dubai-based property giant Nakheel narrowly avoided a similar fate on its sukuk later that year, but was rescued as part of a last-minute bail-out of Dubai by the government of Abu Dhabi.

But many others have not been so lucky. Among the more recent companies to hit problems is Bahraini sharia-compliant investment firm Arcapita, which filed for voluntary bankruptcy in the US courts in March 2012.

Clearly, although Islamic financial institutions have been able to avoid direct exposure to the most problematic elements of the banking world, there are plenty of things that can still go wrong.

“The Islamic financial services industry was by no means immune to the credit crisis and has since suffered its own shocks,” says Samer Hijazi, director of KPMG’s financial services practice. “While Islamic banks cannot invest in interest-based contracts or contracts with no underlying tangible assets, such as derivatives, many had actually invested heavily in asset classes such as real estate and private equity, both in the western world and in some of the emerging markets of the MENA region. As a result, when the wholesale funding markets collapsed, these classes of assets proved to be particularly illiquid, causing many Islamic banks to come close to default and almost collapse.”

The failure of Islamic banks and their regulators to anticipate or avoid such difficulties highlights the problem the sharia-compliant industry has in dealing with the management of risk.

In a speech delivered at the Second Islamic Banking and Finance Conference held in Muscat, Oman in mid-March, the governor of Kuwait’s central bank, Mohammad al Hashel, set out some of the problems as he saw them.

He described risk management as “one of the most serious difficulties confronting [the] Islamic financial industry”. This he attributed to both a lack of suitable tools for measuring risk but also a shortage of necessary expertise, compared with what is available to the conventional finance industry.

“It is the responsibility of Islamic financial institutions to develop the risk management and interior supervision systems, and adopt wise polices in terms of money markets and financial activities,” he said.

“Due attention should be given [by regulators] to ensure sound, sufficient risk management and interior supervision systems of Islamic institutions, including developing the methods applied in risk monitoring and assessment, particularly the stress test methods intended to measure banks’ capabilities to face future crises, which take into account the particulars of Islamic banking activities and the risks involved.”

Risk management is the process by which risks are identified, measured, and, where possible, controlled against or at least mitigated. It is about understanding what you are trading and who you are trading with. For the banking industry as a whole, risk management covers a very broad range of issues, including everything from interest rate movements to creditors failing to meet their obligations and changes in regulations.

Islamic banks, however, face some additional risks that do not concern conventional institutions. They include the risk that a contract is found not to comply with sharia rules and principles, and the equity investment risk that arises from banks entering into a partnership as part of a financing arrangement. There is also limited liquidity in the Islamic banking market and a lack of instruments that can be used as subsidiary financing resources. In many cases sukuk tend to be held until maturity rather than actively traded on the markets, for example.

None of these problems are new, but the industry has been slow in addressing them. In his speech, al Hashel referred to a 2009 report by ratings agency Moody’s Investors Service called ‘The Liquidity/Leverage Trade-off for Islamic Banks and its Impact on their Ratings.’ That set out some of the main issues facing Islamic banks, including weak policies around asset and liability management, weak governance, and a deficiency of risk management policies. “Those issues still do exist,” said the Kuwaiti central bank governor.

Others in the industry appear to share his concerns. In a survey of 20 Islamic financial institutions carried out by professional services firm Deloitte in the second half of 2011, 63 per cent of respondents said that a strong commitment was needed from management and sharia supervisory boards to improve enterprise risk management in Islamic finance. Yet the same survey revealed that only 59 per cent of the institutions had implemented the risk management standard developed by Malaysia’s Islamic Financial Services Board (IFSB) and less than a quarter of respondents had considered or received an external rating from an Islamic rating agency, something which might also provide a level of risk oversight.

The lack of external ratings is one measure of another issue facing the industry, that of transparency.

“The lack of transparency and governance around compliance with sharia banking principles is a rather overlooked challenge,” says Hjazi. “Sharia compliance is at the core of what all Islamic financial institutions claim to bring to the market and yet it is difficult to see how exactly this is managed while some seem to have higher standards than others. I would say progress has been made in this area, but much more needs to be done.”

It is not just a problem for the banks. The Islamic insurance sector, known as takaful, also faces challenges when it comes to risk management. Of course, risk is what insurance companies trade in every day, but in a report released in June this year on the sector, Deloitte pointed out that some important regulatory changes are coming to the sector, which will force them to take an even closer look at their policies. Among the biggest changes being introduced are those contained in the EU’s Solvency II directive which harmonises insurance regulation across Europe. The rules are due to come into force in January 2014.

“Takaful firms are likely to face unprecedented regulatory pressures on their risk management and internal control processes to ensure that the takaful business model and product strategies deliver value to all stakeholders’ interests,” the report says.

The evolving nature of regulations means that Islamic insurance companies may have to adjust their business models, their risk management systems and their sharia board advisors, it added.

The changing regulatory landscape is an issue for Islamic banks as much as it is for Islamic insurance companies. “The wave of regulatory changes and market conditions generally, and the growth in scale and scope of the Islamic industry, have meant that Islamic banks need to review and upgrade their risk management governance and functions to sustain growth and competitiveness,” says Dr Hatim el Tahir, director of the Islamic Finance Knowledge Centre at Deloitte Middle East.

Some of the key challenges that he says need to be addressed include dealing with the inconsistency of regulations in different jurisdictions, inadequate government support and guidance, and a shortage of suitably qualified people in the risk management space. There is also a lack of co-ordination between the arms of governments that set out the regulations and those that oversee their implementation.

“Industry stakeholders need to collaborate more effectively to streamline regulations and practices. In particular they should cultivate a culture of knowledge-sharing and exchange of experiences,” adds El Tahir. “Unless national regulators opt to mandate these standards and enforce them in their respective markets, the industry will continue to face challenges of product offerings, financial reporting inconsistency and inefficient operational and functional issues.”

On the positive side, Islamic institutions have tended to be more conservative than many of their conventional counterparts. As Hijazi points out, they are less likely to deal in high volume complex instruments and also less likely to let bonus considerations influence their risk management process. And the problems around risk management haven’t prevented the Islamic banking sector from growing quickly. The assets of Islamic banks and investment companies in Kuwait, for example, amounted to KD22.3 billion ($78 billion) at the end of last year, equivalent to around 38 per cent of the entire market.

As Islamic banks and other sharia-compliant financial institutions continue to grow, the pressure to develop better risk management tools is only going to intensify.