Dimensions of risk

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					Financial Markets & Institutions

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Fawad Khaleel

Risk is basically a potential of negative outcome, which can arise from current or future processes. (Hetes, 2007a). It is considered to be the inherent consequence of every process, that is not possible to avoid or eliminate altogether (Criddle, 1964 as cited in Hetes, 2007b: 1011). The explanation and interpretation of risk depends on the specific context or applications, as there are multi dimensions to risk, which rang from tangible and quantitative to the psychological and emotional (Hetes, 2007c). Moreover, Kaplan and Garrick described risk as not just the actual outcome that has or will occur, but the complete range of outcomes, their severity and the likelihood (as cited in Hetes, 2007d: 1011). Furthermore, the critical dimension of risk is uncertainty and the outcomes are uncertain, which is the very reason they are risky and unavoidable (Hetes, 2007e: 1011). This concept is further elaborated by Rumsfeld as (taken from Hetes, 2007f: 1011): ‘‘we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones’’. In order to interpret the dimensions of risk on the specific context, a thorough understanding of that specific context is very essential. The risk spectrum of the financial sector is considered to have following types (Investopedia, June 10th, 2008): Market Risk Currency Risk Interest Rate Risk Equity Price Risk Credit Risk Default Risk Settlement Risk Risk through Credit Rating Change Operational Risk Internal Operational Risk External Operational Risk Systematic Risk Un-Systematic Risk Liquidity Risk Model Risk

Financial Markets & Institutions

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Fawad Khaleel

Political Risk Business Risk Legal Risk Furthermore, in order to ensure that the bank act in prudence, in 1974 central bank governors of the G-10 created an institution called, The Basel Committee on Banking Regulations (BCBS). This institution formulates broad supervisory standards, guidelines and recommends statements of best practice in banking supervision (Bank of International Settlements, May 6th, 2008). Kerwer in his work elaborates that BCBS is not like a multilateral organization and the regulations issued by it are not binding. Its main function in to act as an informal forum to find policy solutions (2005: 619). In June 2004, BCBS published Basel II, in an attempt to protect the international financial system by setting up risk and management requirements, which ensure that the bank is holding enough capital reserves, which are appropriate to the risk bank in exposed to, by lending or investments (BIS June 8th, 2008). According to the rule of Basel II more the risk bank practices, more capital it has to hold in order to protect itself from insolvency and also to safe guard economic stability. In order to put into practice its rules, basel II developed three pillars framework (Comptroller of the Currency Administrator of national Bank, June 10th, 2008). The First pillar deals with calculation of regulatory capital for the following Credit Risk is calculated in three different way Standardized Approach Foundation IRB Advanced IRB Operational Risk Basic Indicator Approach Standardized Approach Advanced Measurement Approach Market Risk Value at Risk is used to analyze the market risk, using following three parameters (Holton, 2003:405) 10 days period is used under Basel II to compute capital requirement. Confidence Level is used, which indicates the reliability of Var. VaR is to be expressed in a unit of currency. The Second Pillar implements the regulatory measures, which are triggered on the output of Pillar I. The framework of Second Pillar is also designed to tackle following risks.

Financial Markets & Institutions

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Fawad Khaleel

Residual Risk consists of combination of below mentioned risks Systemic Risk Pensions Risk Concentration risk Strategic Risk Reputation Risk Liquidity Risk Legal Risk The Third pillar of deals the with disclosure. Disclosure are categorized in following types on the basis of concerns (Narain, 2005:4) . Types Voluntary Mandatory Qualitative Quantitative Concerns Accuracy Material Frequency Comparability

For conventional banks, the capital adequacy ratio (car), as stipulated in Pillar 1 of Basel II is expressed as (Ariss and Sasieddine, 2007a: 46-59): Tier 1 Capital + Tier 2 Capital CAR = ––––––––––––––––––––––––––––––––––––––– Risk Weighted Assets However, for Islamic banks the methodology of calculating risk weighting assets is very important, as more risk attached to an asset will require a higher capital base (Ariss and Sasieddine, 2007b: 46-59). The detail structure of calculating risk weighted assets by Basel II does not take into account the dimensions of the risk attached to the activities of islamic bank.

Islamic banking present a unique risk in the financial market. In order to interpret the dimensions of risk for islamic banks, it is important to understand the thorough concept of islamic bank. The islamic bank is considered to be a financial intermediary which not only provides financial instruments in accordance to shari'ah but also the whole practice is filtered through shari’ah.

Moreover, Mishkin explains that the degree of risk attached with a financial product effects its demand in the market (2000: 94). The perception of risk attached with an asset or financial

Financial Markets & Institutions

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transaction dictates its demand in the market. So to have higher demand of financial instruments provided by Islamic bank, Islamic bank tries to reduce the risk attached with these instruments. However due to the nature of the islamic financial products they are considered to be more risky then conventional financial products. The risk attached to these products reduces the demand in the market. This also makes the islamic bank incompatible with the conventional banks. In a process of explaining the problems with the Basel II in regards of Islamic Banks, Schoon points out that (as cited in Analysis: Islamic banking and Basel II: challenges ahead): ‘‘a musharakah that is used for a mortgage would attract the same treatment as a conventional mortgage; if it is used for specialized finance then the regulator could apply “supervisory slotting criteria”; however, if it is used for other purposes then it would attract the same treatment as would an equity holding’ i.e. a three or four hundred per cent risk weighting depending on whether it is public or private equity. This adds to the capital costs of mudarabah and musharakah agreements making them more expensive. This higher cost of capital should be taken into account when advising a client and it may be that alternate structures would meet the client’s needs at a lower cost’’. The treatment of Islamic Bank’s financial products, by regulators is due to its unclear prospective. Moreover, Islamic Bank has been trying to provide a halal alternative to conventional banking. The modes of finance are designed in a shadow of existing conventional products like mortgage, loans and so on. This is because of general perception, that stand alone financial contracts like mudaraba, musharaka, Muharaba and so on, have higher rate of risk attached to them. The Islamic economics concept of equity based financial products, is not practiced because equity being at the bottom of the balance sheet is considered risky investment. The Islamic bank is a financial intermediary and it also has to keep itself solvent within the market to survive, for which equity investment does not help.

Source of funds is different for islamic bank when compared to conventional banks. Moreover, this difference is been accounted and addressed in Basel II. The table below illustrate the difference (Ariss and Sasieddine, 2007c: 46-59):

Financial Markets & Institutions

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Fawad Khaleel

Source of Funds Islamic Banks Current Accounts Saving Accounts Unrestricted Investment Accounts (UIA) Equity : Share Capital + Reserve = Tier 1 Donated Land Reserves (No Preferred Shares or Subordinated Debt Allowed) = Tier 2 No Tier 3 Cumulative Preferred Shares + Subordinated Debt = Tier 2 Tier 3 Portion of subordinated debt available only for market risk Conventional Banks Current Accounts Saving Accounts Time Deposits Certificate of Deposits Equity : Share Capital + Reserve = Tier 1

The Islamic Banks source of funds for their financial and investment activities are unrestricted investment accounts, savings and current account, in addition to share holders equity. The holders of current an savings account are not guaranteed the full payment, as their funds are held in profit and loss sharing basis. While the conventional banks guarantee the full funds and the risk of investment of the funds is bear totally by the conventional bank. As this is not the case with islamic bank as the risk is shared between the depositor and the bank. Moreover, Islamic bank has two kind of investor accounts, restricted and unrestricted. In restricted investment accounts, islamic bank charge just a fee, while all the decisions are taken by the investor. The risk is also bear by the investor, so AAOIFI suggested that these funds should not be included in the islamic banks source of funds and should be included in the off balance sheet items (AAOIFI, 1999). The implication of this is that these funds will not be part of calculation of CAR (Ariss and Sasieddine, 2007d: 46-59). On the other hand the unrestricted investment accounts should be included in the balance sheet, however unrestricted accounts, because of their structure are in between deposit and equity, and this characteristics should be acknowledged in the process of capital adequacy. Ariss and Sasieddine in their research explain the rationale of this as: ‘‘Investment depositors can withdraw their funds upon maturity and reduce the sources

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of funds available to the bank, but the equity base remains unchanged when shareholders 'withdraw their funds' by selling their shares to other investors. Another reason that explains why unrestricted investment accounts cannot be classified under equity or Tier 1 capital is that such account bearers have no voting rights’’(2007e:46-59).

With this concept, AAOIFI purposed the following, method for calculation of CAR (AAOIFI, 1999). Total Capital CAR = ––––––––––––––––––––––––––––––––––––– RWA K&CA + 50% (RWA UIA) (RWA K&CA is the average risk-weighted assets financed through the bank's capital and depositors' current accounts, and RWA UIA is the average risk-weighted assets financed through the unrestricted depositors' investment accounts). This technique overlooks at the structure of calculation of risk weighted assets and is an attempt to use Basel II frame work. Moreover it uses 50% of the risk weight assets in its calculation and does not consider the asset side of balance sheet of islamic bank. Islamic financial services board also purposed a solution, which like AAOIFI uses Basel II as foundation stone. However IFSB considers the uses of funds and allocation of risk for each asset of Islamic Bank. It mainly aims at the following points (Foot, 2004): Identifies the specific structure of modes of financing and products which are offered by Islamic bank and are Shari'ah compliant. This was not considered under Basel II or by the AAOIFI. Establishing a standard for Sharia-compliant products and services by assigning risk weights that are internationally acceptable prudential standards. Defining a structure for the assessment of Islamic financial institutions' capital adequacy requirements. Including market risk not only in the trading book but also in the banking book of Islamic banks because of the nature of the modes of financing such as Murabaha, Ijara, Salam, Musharaka and Mudaraba. In 2005, IFSB issued capital adequacy standards, according to which the proposed calculation of CAR is ( IFSB, June 17, 2008):

Financial Markets & Institutions

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Tier 1 + Tier 2 CAR = ––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––––– RWA(Credit risk + Market risk + Operational risk) – RWA funded by PSIA(Credit
risk + Market risk)

(RWA(Credit risk+Market risk+Operational risk) are those financed by both restricted and unrestricted Profit Sharing Investment Accounts (PSIA). The capital amount of PSIA is not guaranteed by the Islamic financial institution and any losses are to be borne by the Account Holder). Iqbal, El-Hawary and Grais in a research paper proposed another solution that the liabilities and assets should be structured according to the risk for account holders. High risk baring account holder’s fund should be invested separately to low risk baring account holders (2004: 3227). Moreover, another proposal which has found support among the regulators of united kingdom, suggests that liabilities should be re-structured with accordance to the rights of account holders (Davies, 2004). Conclusion In the banking sector supervisory body’s main aim is to protect the depositors. In case of Islamic bank the protection should be of two dimensions. The first dimension should deal with the protection of depositor’s deposits. This protection should mainly be on the similar lines to basel II, although will require a different approach to the problem. The Islamic banks should restructure their source of funds list, in order to send a clear message of its activities and risk attached with them. This will allow islamic bank to move out of conventional umbrella and provide innovative financial solutions. The implementation of right frame work at grass root level should also change the approach of regulatory bodies like financial services authority towards islamic banks in terms of capital adequacy. The right could be dividing current, savings accounts into three accounts: High Risk, High Return Accounts Low Risk, Low Return Accounts Zero Risk, Zero Return Accounts For High Risk, High Return accounts, islamic bank can use mudaraba contract and sell equity to the depositor. This type of account will allow islamic bank to offer higher profit rate compared to conventional banks interest rate. This will attract risk loving depositors who are looking for high

Financial Markets & Institutions

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Fawad Khaleel

rate of return. While for Low Risk, Low Return Accounts, Islamic bank can sell equity from investment from housing market. On the asset side Ijarah House financing product or something similar could be used. The housing market is normally have low risk and different indicators can be used for its forecast, The zero risk, zero return accounts funds can be used in money market. The process of selling equity can be structured as, islamic bank will form a firm ‘F’ with a client ‘A’, on ijarah / diminishing ijarah contract, in a process of selling/renting a house to client ‘A’. This will be the asset side of balance sheet. Islamic bank, will form lets say holds 60% of equity in his firm ‘F’. Moreover, the islamic bank will form a firm ‘E’ and will hold the 60% of equity of firm ‘F’ through firm ‘E’. For the liabilities side, islamic bank will sell the out of 100% equity of firm ‘E’, a decided percentage of equity in terms of investment amount to ‘n’ number of customers on either ‘Low Risk and Low Return Account’ basis. The profit and loss from the 60% of equity will be shared by customers and islamic bank. The islamic bank will leave some percentage of equity in firm ‘E’ for its self. In case of loss islamic bank will be losing the transaction cost of the whole process and the capital loss will be forwarded to the ‘n’ number of customers. While in case of profit all parties will take according to their stake. Meanwhile if ‘x’ number of customer from ‘n’ number of customers want to sell their equity, islamic bank will establish a secondary market, which will be open all players. The profit of the islamic bank can be mathematically explained as: Profit of I.B = [{P(F) × Per(F)}/100]× Per (E)] / 100 While the whole process can be represented as below:

Financial Markets & Institutions

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Fawad Khaleel

With this kind of structure in place, islamic bank will not have to hold a level of capital and will be able to invest 100% of the capital. This will increase the efficiency of islamic bank and will make it more compatible to be a key player in competition in the market. Moreover, the second dimension to the risk is the moral risk. Islamic bank offer shari’ah complaint financial solutions. The depositors main motivation to use islamic bank as their financial intermediary is to have a halal (allowed) financial transaction. The moral risk, is the risk that islamic bank is not practicing in accordance to shari’ah. Moral risk can be classified in the following ways: Transactional Moral Risk Operational Moral Risk Market Moral Risk Transactional moral risk is the risk of having financial transaction not in accordance with shari’ah. While the operational risk is the risk of islamic banks operations not satisfying principles of islamic jurisprudence. Moreover Market risk deals with islamic banks dealing, activities and behavior in the market. Hence the regulatory authority which takes on the task of issuing regulations for islamic bank should also regulate the dimension of moral risk in islamic bank, as the depositors of islamic bank have worldly interest and hereafter interest. So to protect the interest of depositors of islamic bank through regulations, means the regulations have to cater to all the dimensions of risk attached to islamic bank and interest of depositors.

Reference Hetes. Gal (2007a). Science, Risk and Risk Assessment and Their Role(s) supporting Environmental Risk Management. Available at:<URL:http://www.lclark.edu/org/envtl/objects/37-4_Hetes.pdf> Access Date 7th June, 2008.

Financial Markets & Institutions Khaleel

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Hetes. Gal (2007b). Science, Risk and Risk Assessment and Their Role(s) supporting Environmental Risk Management. Available at:<URL:http://www.lclark.edu/org/envtl/objects/37-4_Hetes.pdf> Access Date 7th June, 2008.

Hetes. Gal (2007c). Science, Risk and Risk Assessment and Their Role(s) supporting Environmental Risk Management. Available at:<URL:http://www.lclark.edu/org/envtl/objects/37-4_Hetes.pdf> Access Date 7th June, 2008.

Hetes. Gal (2007d). Science, Risk and Risk Assessment and Their Role(s) supporting Environmental Risk Management. Available at:<URL:http://www.lclark.edu/org/envtl/objects/37-4_Hetes.pdf> Access Date 7th June, 2008.

Hetes. Gal (2007e). Science, Risk and Risk Assessment and Their Role(s) supporting Environmental Risk Management. Available at:<URL:http://www.lclark.edu/org/envtl/objects/37-4_Hetes.pdf> Access Date 7th June, 2008.

Hetes. Gal (2007f). Science, Risk and Risk Assessment and Their Role(s) supporting Environmental Risk Management. Available at:<URL:http://www.lclark.edu/org/envtl/objects/37-4_Hetes.pdf> Access Date: 7th June, 2008.

Bank of International Settlements. Basel II. Available at:<URL:http://www.bis.org/publ/ bcbsca.htm> Access Date 8th June, 2008.

Bank of International Settlements . About Basel Committee. Available at:<URL:http://www.bis.org/ bcbs/index.htm> Access Date: 6th May, 2008.

Comptroller of the Currency Administrator of National Banks (2007). OOC Approces Basel II Capital Rule. Available at:<URL:http://www.occ.gov/ftp/release/2007-123.htm> Access Date: 10th June, 2008.

Das, Satyajit (2007). ‘ Perfect Strom’ - Beautiful & True Lies In Risk management. Available at: <URL: http://www.wilmott.com/blogs/satyajitdas/enclosures/perfectstorms%28may2007%291.pdf> Access Date: 11th June, 2008.

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Davies, H. (2004). Regulatory Issues Facing islamic financial Institutions. IFSB Summit, london, 9th May 2004.

El-Hawary,D., Grais, W. and Iqbal, Z. (2004). Regulating Islamic Financial Institution: The nature of the regulated. Policy Research Working Paper. World Bank p.3227.

Foot, M. (2004). The future of Islamic banking in Britain. IFSB Summit 9th May, 2004. London, UK: IFSB. Islamic Financial Services board (2005). Capital Adequacy Standard for Institutions (Other than Insurance Institutions) Offering Only Islamic Financial Services. Available at:<URL:http:// www.ifsb.org> Access Date: 17 June, 2008.

Kerwer, Dieter (2005). "Rules that many use : standards and global regulation". Governance 18 (4): 611-632. Holton, Glyn A. (2003). Value-at Risk: Theory and Practice. London, UK: Academic Press.

Investopedia. Risk and Diversification. Available at :<http://www.investopedia.com/university/risk/ risk2.asp> Access Date 10th June, 2008.

Mishkin, F.S (2000). The Economics of Money, Banking and Financial Market. Columbia, US: Library of Congress Cataloguing in Publication Data.

+++Narain, A (2005). The Importance of Strengthneing Market Discipline, Transparency in the Financial Sector. Monetary & Financial System Department, IMF at the Semina for Senior Bank Supervisors from Emerging Economies, Washington Oct 18 2005. Available at: <URL: http://wbln0018.worldbank.org/html/FinancialSectorWeb.nsf/(attachmentweb)/FNarain-BaselII-PillarIII/$FILE/F+-+Narain+-+Basel+II+-+Pillar+III.pdf> Access Date: 11th June, 2008.

Schoon, Natalie (2008). Analysis: Islamic banking and Basel II: Challenges ahead. Available at:<URL:http://www.newhorizon-islamicbanking.com/index.cfm? section=features&action=view&id=10625> Access Date 9th May, 2008.

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