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Risk Analysis for Islamic Banks

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Risk Analysis for Islamic Banks 42481 RISK ANALYSIS FOR Public Disclosure Authorized Islamic BANKs Public Disclosure Authorized Public Disclosure Authorized Hennie van Greuning Zamir Iqbal Public Disclosure Authorized Risk Analysis for Islamic Banks Risk Analysis for Islamic Banks Hennie van Greuning and Zamir Iqbal THE WORLD BANK Washington, D.C. ©2008 The International Bank for Reconstruction and Development / The World Bank 1818 H Street NW Washington DC 20433 Telephone: 202-473-1000 Internet: www.worldbank.org E-mail: [email protected] All rights reserved 1 2 3 4 5 10 09 08 07 This volume is a product of the staff of the International Bank for Reconstruction and Development / The World Bank. The findings, interpretations, and conclusions expressed in this volume do not necessarily reflect the views of the Executive Directors of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work. The boundaries, colors, denominations, and other information shown on any map in this work do not imply any judgement on the part of The World Bank concerning the legal status of any territory or the endorsement or acceptance of such boundaries. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development / The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center Inc., 222 Rosewood Drive, Danvers, MA 01923, USA; telephone: 978-750-8400; fax: 978-750-4470; Internet: www.copyright.com. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW,Washington, DC 20433, USA; fax: 202-522-2422; e-mail: [email protected]. ISBN-13: 978-0-8213-7141-1 eISBN-13: 978-0-8213-7142-8 DOI: 10.1596/978-0-8213-7141-1 Library of Congress Cataloging-in-Publication data has been applied for. CONTENTS Foreword–Kenneth G. Lay xiii Foreword–Dr. Shamshad Akhtar xv Acknowledgments xix About the Authors xxi Acronyms and Abbreviations xxiii Part One: Principles and Key Stakeholders 1 Principles and Development of Islamic Finance 2 Principles of Islamic Financial Systems 4 Development and Growth of Islamic Finance 10 2 Theory and Practice of Islamic Financial Intermediation 16 Structure of Financial Statements 18 Basic Contracts and Instruments 21 Islamic Financial Institutions in Practice 25 3 Corporate Governance: A Partnership 30 Supervisory Authorities: Monitoring Risk Management 32 The Shareholders: Appointing Risk Policy Makers 34 The Board of Directors: Ultimate Responsibility for a Bank’s Affairs 35 Management: Responsibility for Bank Operations and the Implementation of Risk Management Policies 37 v Contents The Audit Committee and Internal Auditors: An Assessment of the Board’s Risk Management Implementation 41 External Auditors: A Reassessment of the Traditional Approach of Auditing Banks 44 The Role of the General Public 45 4 Key Stakeholders 50 Internal Stakeholders 50 Multilateral Institutions 53 Regulatory Bodies 58 Part Two: Risk Management 5 Framework for Risk Analysis 64 Risk Exposure and Management 64 Understanding the Risk Environment 68 Risk-Based Analysis of Banks 72 Analysis versus Computation 74 Analytical Tools 76 Analytical Techniques 79 6 Balance-Sheet Structure 88 Composition of Assets 91 Composition of Liabilities 96 Equity 99 Balance-Sheet Growth and Structural Change 99 7 Income Statement Structure 102 Composition of the Income Statement 104 Income Structure and Earnings Quality 109 Profitability Indicators and Ratio Analysis 114 8 Credit Risk Management 120 Formal Policies for Managing Credit Risk 120 Policies to Reduce Credit Risk 121 Credit Risk Specific to Islamic Banks 126 vi Contents Analyzing Credit Risk in the Asset Portfolio 127 Asset Classification and Loss Provisioning Policies 133 Review of Risk Management Capacity 138 9 ALM, Liquidity, and Market Risks 144 Asset-Liability Management (ALM) 146 Liquidity Risk 150 Market Risk 156 Market Risk Measurement 163 Market Risk Management 168 Notes 172 10 Operational and Islamic Banking Risks 174 Operational Risk 174 Risks Specific to Islamic Banking 176 Reputational Risk 181 Part Three: Governance and Regulation 11 Governance Issues in Islamic Banks 184 Stakeholder-Based Governance Model 184 Role and Responsibilities of Shariah Boards 187 Issues in Shariah Governance 189 Shariah Review Units and Other Structures 191 Improvement in Shariah Governance 192 Investment Account Holders as Stakeholders 193 Financial Institutions as Stakeholders 196 12 Transparency and Data Quality 200 Transparency and Accountability 200 Limitations of Transparency 203 Transparency in Financial Statements 204 Disclosure and Data Quality 206 Deficiencies in Accounting Practices 210 Applicability of IFRS to Islamic Banks 211 Transparency and Islamic Financial Institutions 214 vii Contents 13 Capital Adequacy and Basel II 218 Significance of Capital in Banking 219 Basel I and Basel II 221 Pillar 1: Capital Adequacy Requirement 222 Capital Adequacy Methodology for Islamic Banks 224 Pillar 2: Supervisory Review 231 Pillar 3: Market Discipline 233 Managing Capital Adequacy 234 14 The Relationship between Risk Analysis and Bank Supervision 240 The Risk Analysis Process 241 The Supervisory Process 245 Consolidated Supervision 251 Supervisory Cooperation with Internal and External Auditors 254 Part Four: Future Challenges 15 Future Challenges 258 Areas for Improvement 258 Steps Forward: Some Recommendations 261 Regulation, Governance, and Transparency 269 References 276 Appendices A Glossary of Islamic Terms 281 B IFSB Standard on Risk Management 285 C Proposed Outline for Bank Analytical Reports 293 Index 297 BOXES 1.1 Principles of an Islamic Financial System 7 3.1 Accountability of Bank Management 38 3.2 Fit and Proper Standards for Bank Management 39 3.3 The Responsibilities of Management 40 3.4 The Responsibilities of Audit Committees and Internal Auditors 44 viii Contents 3.5 The Responsibilities of External Auditors 45 8.1 IFSB Principles of Credit Risk 122 8.2 Content of an Investment and Financing Asset Review File 131 8.3 Signs of a Distorted Credit Culture 134 8.4 Asset Classification Rules 135 9.1 IFSB Principles of Liquidity Risk 154 9.2 IFSB Principle of Market Risk 156 9.3 IFSB Principles of Rate-of-Return Risk 159 9.4 IFSB Principles of Equity Investment Risk 160 11.1 IFSB Principles of Corporate Governance for Islamic Banks 198 12.1 Criteria for Evaluating Accounting Standards 205 12.2 Survey on Public Disclosure of Banks 212 12.3 AAOIFI Standards 213 13.1 IFSB Principles for Minimum Capital Adequacy Requirements (CAR) 226 13.2 IFSB Standard Formula for CAR 227 13.3 IFSB Supervisory Discretion Formula for CAR 227 13.4 Computation of CAR for an Islamic Bank 231 FIGURES 2.1 Contracts and Instruments 22 3.1 Partnership in Corporate Governance of Banks 33 5.1 Composition of an Islamic Bank’s Assets, by Periods 80 5.2 Trends in Asset Growth, by Period 81 6.1 Composition of an Islamic Bank’s Balance Sheet 90 6.2 Structure of an Islamic Bank’s Assets 91 6.3 Structural Change and Asset Growth, 2001–06 92 6.4 Growth of Assets, Year on Year 92 6.5 Hypothetical Growth of Assets 101 7.1 Asset Structure versus Income Structure 111 7.2 Relationship of Income to Expenses, 2001–06 112 7.3 Select Profitability Ratios 2001–06 116 7.4 Additional Profitability Ratios, 2001–06 116 7.5 Example: Return on Assets (ROA) and on Equity (ROE), Adjusted for the Cost of Capital 118 8.1 Exposure to 20 Largest Exposures (Hypothetical Example) 123 8.2 Customer Profile: Who Are We Investing In? 128 8.3 Composition of Islamic Products: What Are We Investing In? (2006 Compared to 2001) 128 ix Contents 8.4 Year-on-Year Fluctuations in Growth of Portfolio Components 141 9.1 Liquidity Mismatches (Derived from Maturity Profile of Assets and Liabilities) 153 9.2 Cash Flows (Derived from Cash Flow Statements) 153 9.3 Exposure to Marketable Securities, 2001–06 164 9.4 Simplistic Impact on Equity of Marking to Market 168 11.1 Corporate Governance Structures in Institutions Offering Islamic and Conventional Financial Services 186 12.1 Transparency in Financial Statements Achieved through Compliance with the IFRS Framework 207 13.1 Framework for Measuring Credit Risk Weights 229 13.2 Framework for Measuring Market Risk Weights 230 13.3 Components of Bank Capital 234 13.4 Risk Profile of Assets 235 13.5 Capital Tiers and Compliance 238 13.6 Potential Capital Shortfall Assuming Continued Average Growth in Assets and Capital 238 14.1 The Context of Bank Supervision 242 TABLES 1.1 Development of Islamic Economics and Finance in Modern History 13 2.1 Theoretical Balance Sheet of an Islamic Bank Based on Maturity Profile and Functionality 19 2.2 Sources and Application of Funds 21 2.3 Size of Islamic Financial Institutions in 1999 26 4.1 Importance of Key Stakeholders in the Islamic Finance Industry 52 5.1 Banking Risk Exposures 65 5.2 Contractual Role and Risk in Islamic Banking 69 5.3 Stages of the Analytical Review Process 76 5.4 Balance-Sheet Composition of Assets 82 5.5 Balance-Sheet Growth, Year on Year 85 6.1 Composition of an Islamic Bank’s Balance Sheet 90 6.2 Islamic Financing and Investing Assets Grass 94 6.3 Percentage
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