Risk Management for Islamic Banks Recent Developments

Advance Praise “The importance of risk management for Islamic financial insti- tutions cannot be understated. As many would believe, a rather sluggish integration of Islamic finance into the global-mainstream financial industry is due to a lack of globally accepted risk manage- ment standards that provide a solid and sustainable foundation. In filling such a gap, I therefore commend the authors for eloquently demonstrating a comprehensive overview of risk management the- ory and practices in Islamic financial institutions. The publication of this book, hence, is both timely and a reminder that sound risk management is fundamental to good business management – be it conventional or Islamic – and will subsequently lead to an advan- tageous business environment.” – Hylmun Izhar, Economist, Islamic Research and Training Institute, Islamic Development Bank Group “Prudent risk management of Islamic Banks is a primary require- ment in maintaining Islamic banking as a highly competitive, sound, robust and profitable industry. This will also facilitate the super- visory duties of the Indonesian Financial Services Authority and create an Islamic banking industry that is healthy on the micro and macro scale. The application of comprehensive risk management is expected to effectively protect the industry as well as the customers from the various possible bank deviations. The presence of this book is part of the important efforts to enrich the repository of knowledge on risk management of Islamic banks.” – Muliaman D. Hadad, Chairman, Board of Commissioners, Financial Services Authority of Indonesia “Advancement of information technology and the increasingly rapid and unexpected changes in the financial world contribute to the development of a more complex and risky Islamic banking indus- try. The need for comprehensive risk management in Islamic banks cannot be denied. Therefore, all the stakeholders in the Islamic bank business should have good understanding and awareness of the risks

involved and how to manage them. This book approaches Islamic banking from the perspective of literature study, regulation assess- ment, and analysis of the practices in the field. It is a worthy refer- ence, and a worthy contribution to Islamic banking.” – Iggi H. Achsien, Independent Commissioner, PT Bank Muamalat Indonesia Tbk

Risk Management for Islamic Banks

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Risk Management for Islamic Banks Recent Developments from Asia and the Middle East IMAM WAHYUDI FENNY ROSMANITA MUHAMMAD BUDI PRASETYO NIKEN IWANI SURYA PUTRI

Copyright © 2015 by John Wiley & Sons Singapore Pte. Ltd. Published by John Wiley & Sons Singapore Pte. Ltd. 1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as expressly permitted by law, without either the prior written permission of the Publisher, or authorization through payment of the appropriate photocopy fee to the Copyright Clearance Center. Requests for permission should be addressed to the Publisher, John Wiley & Sons Singapore Pte. Ltd., 1 Fusionopolis Walk, #07-01, Solaris South Tower, Singapore 138628, tel: 65-6643-8000, fax: 65-6643-8008, e-mail: [email protected]. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor the author shall be liable for any damages arising herefrom. Other Wiley Editorial Offices John Wiley & Sons, 111 River Street, Hoboken, NJ 07030, USA John Wiley & Sons, The Atrium, Southern Gate, Chichester, West Sussex, P019 8SQ, United Kingdom John Wiley & Sons (Canada) Ltd., 5353 Dundas Street West, Suite 400, Toronto, Ontario, M9B 6HB, Canada John Wiley & Sons Australia Ltd., 42 McDougall Street, Milton, Queensland 4064, Australia Wiley-VCH, Boschstrasse 12, D-69469 Weinheim, Germany Library of Congress Cataloging-in-Publication Data Wahyudi, Imam, 1981– Risk management for Islamic banks : recent developments from Asia and the Middle East / Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo, Niken Iwani Surya Putri. pages cm. – (The Wiley finance series) Includes bibliographical references and index. ISBN 978-1-118-73442-1 (cloth) – ISBN 978-1-118-73443-8 (epdf) – ISBN 978-1-118-73445-2 (epub) 1. Banks and banking–Religious aspects–Islam. 2. Banks and banking–Risk management–Islamic countries. I. Title. HG3368.A6W34 2016 332.1068′1 – dc23 2015019100 Typeset in 10/12pt, SabonLTStd-Roman by SPi Global, Chennai, India Cover Design: Wiley Cover Image: © iStock.com/javarman3 Printed in Singapore by C.O.S Printers Pte Ltd 10 9 8 7 6 5 4 3 2 1

In the Name of Allah, the Most Merciful, the Most Beneficent. I dedicate this book to: My beloved mother—Siti Choirotun hafidhahallahu My father—Imam Munajat hafidhahullahu Our teacher—Bambang Hermanto rahimahullahu Both of my siblings—Yusuf Karomaini, Anita Citra Sari My family—Dian Amalia, Rini Rohimah, Asiyah, Ibrahim, Yahya, Musa —Imam Wahyudi

Contents Preface xv Acknowledgments xxi About the Authors xxiii List of Acronyms xxv PART ONE 3 Introduction 3 5 CHAPTER 1 6 Principles of the Islamic Financial System Islamic Financial Contracts: The li-tabarru’ Contract versus 9 li-tijari Contract Principles of Islamic Finance 10 Interest-Based Return versus Profit–Loss Sharing 11 12 CHAPTER 2 16 The Islamic Bank and Risk Management 20 Differences between an Islamic Bank and a Conventional 27 Bank 28 History of the Islamic Bank 28 Global Islamic Banking Entities Risk as an Integral Part of Islamic Bank Stages in Risk Management Risk and Return Trade-Off Various Approaches on Risk Identification The Importance of Risk Management for an Islamic Bank ix

x CONTENTS PART TWO 33 34 Risk Management Framework in Islamic Banking 36 40 CHAPTER 3 43 History of Risk Management in Islamic Banking 44 Basel I and Its History Basel II and Its History 47 Basel III and Its History 47 The AAOIFI and Its Role 56 The IFSB and Its Role 57 61 CHAPTER 4 62 The Risk Management Process in Islamic Banking 62 Risk Management Model in Islamic Banks 66 Risk Identification Process in Islamic Banking Risk Matrix 72 Risk Mitigation Process 72 Risk Review Process 74 Infrastructure and Facilities 78 Calculation of Minimum Capital Requirements 80 87 CHAPTER 5 88 Financial Reporting and Analysis in Islamic Banking 89 The Importance of Financial Statements in Risk Analysis 92 Scope of Financial Statement in Islamic Banks 101 Basic Contracts and Instruments in the Islamic Bank Structure of the Balance Sheet Analysis of Income Statement Persistence Analysis Tools of Financial Statement Analysis Core Business Activity in Islamic Banks Off-Balance Sheet Activity in Islamic Banks PART THREE 107 Risk Management in Islamic Banking 107 108 CHAPTER 6 Financing Risk in Islamic Banking Urgency of Financing Risk Management in Islamic Banking Characteristics of Islamic Financing Contracts

Contents xi Financing Risk: Definitions and Its Scope 110 Role of Rahn and Kafalah 112 Defining Determinant Factors of Financing Risk 114 Urgency of the Independent Rating Agency 128 Rating and Financing Risk Provisions 130 Risk-Based Financing Limit 133 Concentration Risk in Financing Portfolio 133 Financing Portfolio Management 135 Measuring Financing Risk in the Islamic Bank 139 CHAPTER 7 144 Operational Risk in Islamic Banking 144 Urgency of Risk Awareness 145 Operational Risk Coverage in Islamic Banks 149 Identification of Operational Risk Factors 155 Operational Risk in Islamic Financial Contracts 160 Measurement of Islamic Operational Risk 166 Developing an Operational Risk Management System 168 CHAPTER 8 Syari’ah Compliance Risk 169 Basic Principles of Islamic Economics and Financial 170 System 172 Syari’ah as Principle and Spirit in Business Various Prohibitions in Mu’amalah 175 Why Should Islamic Banking Comply with Islamic 176 Principles? Integrating Syari’ah Compliance in the Islamic Bank 177 Evolution of Syari’ah Governance in Islamic Financial System 179 Syari’ah Advisory Board and Syari’ah Compliance 183 Audit as a Framework Identification Process of Syari’ah Compliance Risk 187 Risk Management and Mitigation of Syari’ah Compliance 188 Risk Models of Syari’ah Governance in Several Countries 194 195 CHAPTER 9 196 Strategic Risk 204 Definition and Scope of Strategic Risk in Islamic Banking Determinants of Strategic Risk and Its Mitigation Issues Related to Strategic Risk

xii CONTENTS CHAPTER 10 209 Investment Risk in Islamic Banking 209 Syirkah as a Distinct Trait of Islamic Banks 210 Basic Concept of Investment Risk 216 Forms of Risk and Their Mitigation 230 Regulations on Profit Distribution Management 232 CHAPTER 11 233 Market Risk in Islamic Banking 234 Urgency of Market Risk 239 Scope of Market Risk in Islamic Banks 244 Identification of Market Risk Profile 253 Market Risk Measurement in Islamic Banks 256 Market Risk Mitigations in Islamic Banking Implementation of Market Risk Mitigation 264 264 CHAPTER 12 265 Liquidity Risk in Islamic Banking 267 Urgency of Liquidity Risk 271 Credit Multiplier, Financial Stability and Liquidity Crises 272 Definition and Coverage of Liquidity Risk Islamic Bank’s Assets and Liabilities Liquidity Risk Management in Islamic Banks PART FOUR 285 286 Future Prospects and Challenges in Islamic Banking 292 294 CHAPTER 13 295 Development of the Islamic Financial Market Islamic Capital Market 296 Derivative Islamic Market Regulation and Supervisory in Islamic Financial Market 299 Institutional-Based Development Framework 299 Stability in Islamic Financial System: Lesson from Global 302 Financial Risk 305 314 CHAPTER 14 Development of a Pricing Model in Islamic Banking Fundamentals in Islamic Pricing Model Time Value of Money in Pricing Model Current Islamic Pricing Model Urgency of Pricing Mechanism in Islamic Banks

Contents xiii CHAPTER 15 315 Pathways of Risk Management in Islamic Banks 315 Islamic Banks as Real Implementation of Risk Management 317 Challenges of Islamic Banking in the World 319 Blueprint for Islamic Banking Regulation 323 Prospects and Challenges of Islamic Banking Development Strategic Issues in the Implementation of Islamic Risk 324 Management 328 CHAPTER 16 329 Future Agenda 330 Landscape of Integrated Islamic Risk Management 331 Synergy and Integration among Islamic Financial Institutions 333 Competency and Competitiveness of Islamic Banking 335 Regulatory Agenda in the Future Anticipating the Potential Systemic Risks PART FIVE 345 Conclusion CHAPTER 17 Summary and Conclusion Glossary 350 Bibliography 359 Index 383

Preface The Islamic bank is a financial institution that is established and managed under the principles of Islamic syari’ah and is universal in its practices in improving welfare for mankind. Right now, the Islamic bank is growing and developing rapidly. Even so, as time passes, the risk and challenges faced by the Islamic bank will become more complex and extensive; thus, the future of the Islamic bank is highly reliant on its abilities to anticipate changes in the financial world; such as the effects of globalization, the chain reaction of effects that can take place when a crisis occurs, and the rapid development of information technology. The financial sector is also more dynamic, competitive, and complex; and often creates a new risk in the financial system, such as the too-connected-to-fail risk or the displaced commercial risk. In performing various financial functions and services, the Islamic bank will certainly face various risks, both financial as well as nonfinancial. The bank should be able to manage various risks faced well, without reducing or sacrificing performance, service quality, operational ease, or targets set by the bank’s owners. If the bank is able to manage risk appropriately, then not only will the bank avoid the more obvious risks, but the Islamic bank can also change that risk into a business opportunity that can generate profit for the bank. The rapid development of Islamic banks has been followed by other Islamic financial institutions, such as Islamic insurance, Islamic leasing companies, Islamic venture capital, Islamic capital market, Islamic money market, Islamic microfinance institutions, and the like. These institutions often interact with one another, both directly and indirectly. Interconnection occurs through financial institutions between them, both on the asset side (financing or fund placement in other institutions); while indirect intercon- nection occurs through indirect investment activities (or issuing securities) in the financial market. Other than the interconnection between financial institutions, the product and operating activities of the Islamic bank are also developing into more complex and sophisticated forms, making it necessary to develop risk management and analysis that is also more comprehensive. Like the sides of a coin, the rate-of-return and risk will always be attached to each other in a business. Islam admits the presence of profit the same way it admits the presence of risk. In a fiqh principle, it is stated, “al ghunmu bil ghurmi” and “al kharaju bidh dhamani,” also known under the modern financial term of “risk-return trade-off.” The application of xv

xvi PREFACE reliable risk management is just as important as the application of various business strategies to optimize rate-of-return. A bank’s birth is similar to that of a baby with permanent and inconveniencing disabilities; the bank will always exist in a state of permanent mismatch liquidity, and bears the risk from it. Even if the Islamic bank is able to reduce and even eliminate its finan- cial risks, such as default risk, market risk, operational risk, rate-of-return risk, investment risk, and various other nonfinancial risks such as reputa- tion risk, syari’ah-compliance risk, strategic risk, and other business risk, the Islamic bank will still face liquidity risk. This means that the bank’s failure in managing various risks, other than liquidity risk, will worsen the bank’s already-present “flaw.” Under extreme conditions, the bank will be paralyzed and unable to perform its role as financial intermediary. A well-designed risk management approach, accommodating the dis- tinct products and operating activities of an Islamic bank and performed with utmost prudence, is the prerequisite of maintaining the existence of the Islamic bank as a highly competitive institution: prudent, profitable and able to generate loyalty in its customers. Apart from that, a well-managed risk will also ease the regulator in performing its duties in monitoring the Islamic bank’s risks and ensuring the banking industry’s health, both on a micro as well as macro level. This is in line with the authority of regulators in every country related to the supervision and management of the banking industry and ensures that prudential principles are followed in a bank’s business activ- ities. These activities include risk management, bank governance, and the principle of knowing your customer; prevention against money-laundering and terrorism and criminal enterprise financing; and bank checks. The appli- cation of comprehensive risk management in the Islamic bank is expected to be able to protect the banking industry and depositors from various possible aberrations that can occur, as well as mismanagement. The coverage of risk is very wide and is as extensive as the business process run by the bank itself. In principle, risk is attached to every business activity. To understand the framework of risk management comprehensively and holistically, the Islamic bank’s business processes will first need to be understood in detail: the innovation process and development of banking products, the creation of contracts and their different maturities, the methods the bank uses to place itself in the customer’s perspective as well as its stakeholders, and so on. Various questions on the bank’s existence and survival need to be asked and answered to build a reliable risk management system for the bank. Related to that issue, various existing literature tend to choose one of two approaches: The first approach explains the risk management framework from the approach of risk measurement. In the first approach, each risk has a distinct characteristic, philosophy, and trait. For that, we often find one book that specializes in discussing various methodologies, methods, and market risk measurements. Other

Preface xvii books specialize in discussing the measurement of credit risk, while yet others cover operating risk and the like. The second approach is the book or literature that discusses how risk management is built in part as a system, as in the application of enterprise risk management (ERM). In this book, it usually explains how a bank or another institution integrates risk management into the entire element of the business unit. Risk management is not treated as a separate business function, but is integrated with vision, mission, planning, and performance measurement. Whether the bank’s goals are achieved or not is not only determined by the fulfilment of the bank’s return target, but also by the risk measure applied. The two approaches require a basic understanding of an Islamic bank’s business process and also of the characteristic, philosophy, and distinct trait of each risk faced. Up until now, we have yet to encounter a single book or literature that tries to clearly explain the two prerequisites. As such, we endeavor to analyze various business processes present in Islamic banking. We try to identify the existence of risk and its type, as well as understand the characteristics, philosophy, and distinct character of each risk. All these we have tried to write in this book. This book does not begin from a case study of any particular Islamic bank, but discusses the common traits of Islamic banking around the world. The approach that we use is a combination of regulation analysis, literature study and analysis of field practices on several Islamic banking institutions. Various findings and analyses of field practice are used as a basis to draw general conclusions on the character and practice of the Islamic banking industry. This book consists of five parts. Part I is the introduction and consists of two chapters: Chapter 1 discusses the basic philosophy of the Islamic financial system, including the banks. Specifically, this chapter will discuss the characteristics of Islamic finance and the concept of usury that is prohib- ited in Islam. Chapter 2 will explain Islamic banks and risk management, various global institutions related with an Islamic bank’s activities (e.g., the Islamic Financial Services Board [IFSB], the Basel Committee on Banking Supervision [BCBS], and the Accounting and Auditing Organization for Islamic Financial Institutions [AAOIFI]), as well as best practices of bank governance. The chapter also discusses the philosophy of risk management, especially related to the meaning and concept of risk, the understanding that risk is inseparable from the Islamic bank, the stages of risk management practices, the relevance of risk and rate-of-return, Islamic perspective on risk, risks faced by the Islamic bank, various approaches to recognizing risk and the benefits that can be reaped by the Islamic bank from good risk management. Part II discusses the risk management framework in the Islamic bank. This part consists of three chapters: Chapter 3 discusses the history of risk management development in Islamic banks. It begins by discussing why

xviii PREFACE the bank will need to be managed and supervised, why various regulations emerged, and why it is necessary to create an agreement on operating ground rules in the global financial system, then continues with discussions of Basel I, Basel II, and Basel III. The framework and coverage of these three frameworks are discussed to understand the reason for various amendments and revisions. Then, Chapter 3 specifically discusses Islamic bank accounting standards. This discussion is important considering various measurements, methods, and risk models are based on accounting systems and reporting. The end of Chapter 3 discusses the risk management framework in the IFSB as a community of global Islamic financial institutions, and various regulations that are specifically issued by Bank Indonesia as Indonesia’s banking regulator. In Chapter 4, this book discusses the risk management process in an Islamic bank. Specifically, the chapter explains the philosophy that risk management is a continuous process, then enters the topic of risk management models in an Islamic bank along with the risk identification process, the development of the risk matrix, the risk mitigation process, and the risk review process. The final part of Chapter 4 will discuss various facilities and infrastructure necessary for the construction of a reliable risk management system. Chapter 5 covers the Islamic bank’s financial statements and related analyses. In this chapter, we will explore the details related to the structure of financial statements (on balance sheet, income statement, off balance sheet, etc.), the philosophy of financial statement construction, the available financial statement analysis tools, and how to integrate financial statement analysis into the risk management framework. Part III will specifically discuss the characteristic, profile, philosophy, coverage and distinct character of all the risks faced by the Islamic bank. Apart from that, there will also be an explanation of the identification process of “key risk factors” of the business process of each product and the bank’s business activities, how the tools and policies of risk mitigation are constructed, and various issues related to those risks in the framework of developing the Islamic banking institution. This part consists of seven chapters. Chapter 6 discusses financing risk in an Islamic bank, including the function of the Islamic bank, the urgency of financing risk management in an Islamic bank, the Islamic bank’s financing risk profile, the defini- tion and scope of financing risk, the role of rahn (asset collateral) and kafalah (third party guarantee), and various other factors that determine financing risk. Afterward, the urgent need for an independent rating agency is also discussed, as are the role of financing risk provision, financing limit strategies based on risk profile, concentrated financing portfolio risks, the management of financing portfolios, and how to construct the best practice of financing risk management by optimizing the synergic relationship between interrelated institutions. Chapter 7 discusses the Islamic bank’s operational risk; it covers the concept and definition of

Preface xix operational risk, the relation between operational risk and Islamic bank’s business, the importance of building consciousness on the presence of risks when operating the business, the definition and scope of operational risk, identification of the various determining factors of operational risk, how to measure operational risk in an Islamic bank, and how to build a reliable operational risk management in an Islamic bank. Chapter 8 discusses syari’ah-compliance risk. This risk needs to be cov- ered in higher detail, considering many Islamic banks carry the mission of manifesting the principles of Islamic syari’ah in the Islamic bank’s business practices. In this chapter, the basic principles of Islamic financial system and economy are discussed; the basic philosophy that syari’ah is the principle and spirit in business, as well as the various prohibitions in mu’amalah. Why the Islamic bank should be syari’ah-compliant in its business is also discussed, as well as the ways that syari’ah-compliance should be an integral part of policies and management processes at all levels of the Islamic bank, the urgency for the national syari’ah council and the existence of a syari’ah supervisory board in an Islamic bank, and the relationship between the syari’ah supervisory board and the syari’ah-compliance audit as part of a framework. The final part of this chapter discusses the syari’ah-compliance risk identification process and how to build risk management and mitigation for syari’ah-compliance in an Islamic bank. Chapter 9 covers an Islamic bank’s strategic risks. This chapter specif- ically discusses the concept of strategic risk for the Islamic bank, the scope and definition of strategic risk, the determinants of strategic risk, and how to mitigate it, as well as the issues relevant to strategic risk. Chapter 10 dis- cusses investment risk in an Islamic bank. This chapter covers syirkah as a distinct characteristic of Islamic banks, the basic concept of investment risk, the forms of investment risk and its mitigation, as well as covering several issues related to investment risk in an Islamic bank, such as the basis of deter- mining profit-sharing ratios, the policy of profit equalization reserve (PER), investment risk reserve (IRR), and investment risk (IR) support in reducing fraud and moral hazard in a profit-loss-sharing-based contract. Chapter 11 discusses an Islamic bank’s market risk. The beginning of the chapter will touch on the basic differences between the market risk of a conventional bank and those of an Islamic bank. Then, we will discuss the identification process and measurement of market risk in an Islamic bank, the mitigation method that is appropriate to the Islamic bank’s character, and the application of risk mitigation methods in an Islamic bank. Chapter 12 discusses liquidity risk in an Islamic bank. This chapter specifically discuss the definition, basic concept, and philosophy of liquidity risk for a bank, as well as the definition and scope of liquidity risk, asset, and liability manage- ment in an Islamic bank. Last, liquidity risk management for Islamic banks will also be discussed.

xx PREFACE Part IV discusses the potential and challenges of the Islamic bank in the future. This part consists of four chapters. Chapter 13 covers the develop- ment of the Islamic financial market, both from the institutional side as well as from the financial products traded. Chapter 14 discusses the development of pricing methods in the Islamic bank. It discusses the urgency for Islamic banks to develop their own pricing systems independent from a usurious reference rate, such as the market interest rate. Various approaches are dis- cussed, such as the microeconomic of banking approach, the real sector’s rate-of-return, the productivity-based pricing model, and the like. Specifi- cally, we provide an illustration of pricing construction on a salam product; from this, the pricing method for other Islamic financial products can conse- quently be developed. Chapter 15 covers the pathways of risk management in an Islamic bank and various related issues, beginning from correcting any possible misapprehension on the Islamic bank, and how the Islamic bank itself is an actual implementation of risk management. The Islamic bank is an alternative and practical solution compared to the weakness of the cur- rent conventional financial system. After this, we will discuss sequentially the challenges faced by Islamic banking in Indonesia as well as the blueprint for Islamic banking. Other important issues are the potential for moral hazard and the lack of a global super-body institution, such as an international arbi- trage and mediation institution for Islamic banks, an international syari’ah judicial institution, or a global regulator. This chapter also discusses the development potential of Islamic banks and their challenges, the strategic issues of risk management application in an Islamic bank, as well the form of Islamic banking risk management in the future. The pros and cons of syari’ah-based products and syari’ah-compliant products will be discussed, as well as the risks behind the usage of profit-loss-sharing scheme, the impli- cations of mudharabah mutlaqah versus mudharabah muqayyadah, and how the Islamic bank answers the challenge of creating a syari’ah-compliant prod- uct. Then, Chapter 16 discusses the future agenda of Islamic bank’s risk management development, the potential for synergy between Islamic finan- cial institutions, the requirements and competencies that must be built and prepared for, and the direction of regulation in the future. To build Islamic banking risk management in the future, continuous development of the risk management system and an integrated risk management landscape develop- ment. Finally, Part V is the conclusion of this book. Imam Wahyudi Fenny Rosmanita Muhammad Budi Prasetyo Niken Iwani Surya Putri Depok, March 2015

Acknowledgments Alhamdulillahi Rabbil ‘alamiin, all praises belong only to Allah Ta’ala. With His blessings and favors, this book can be finished. It is true what is advised by Imam Muhammad bin Idris asy-Syafii al-Quraisy rahimahullahu Ta’ala: O my brother … knowledge is not gained unless through six things that I will tell in detail: intelligence, passion, earnestness, sufficiency (of capital), befriend (study from) a teacher, and it requires a long time (patience). The same can be said of the construction of this book. Without passion, earnestness, and patience, it would not have been possible for us to finish it. This book is the result of further research on our first book, Manajemen Risiko Bank Islam [Risk Management in Islamic Bank], which uses cases in the Islamic banking industry in Indonesia. The first research was done with the funding and data support related to the real practises of Bank Mu’amalat Indonesian and Muamalat Institute. For that, we express our gratitude—“jazakumullahu khairan” (may Allah reward you all with kindness)—to Bank Muamalat Indonesia dan Muamalat Institute, espe- cially for Mr. Andi Bukhari, Ms. Etien Syafitri and Mr. Yudi Susworo. We also do not forget to express our thanks to our colleagues, Mr. Ardiansyah and Mr. Alfiansyah from the Syari’ah Compliance Division and the Risk Management Division of Bank Muamalat Indonesia. The discussions we’ve had with them contribute to a maturing understanding over the application of risk management in Islamic banking. We also express our gratitude to our teachers and colleagues, Mr. Irwan Adi Eka Putra, Mr. Adi Zakaria Afif, Mr. Musthafa Edwin Nasution, Mr. Jossy Prananta Moeis, Mr. Ruslan Prijadi, Mr. Zaafry A. Husodo, and Mr. Buddi Wibowo. May we always receive the blessing and pleasure of Allah Ta’ala over every process of our search for knowledge, its practice, and the teaching of that knowledge, both in class as well as in the community. Finally, we do not forget to thank our assistants, Rizky Nugrahani and Nur Dhani, who had helped us in the construction of this book, as well as our comrade-in-arms in the Syari’ah Economics and Business Centre—Faculty of Economics xxi

xxii ACKNOWLEDGMENTS and Business, University of Indonesia, Yusuf Wibisono, Banu M. Haidir, Rahmatina A. Kasri, Miranti Kartika Dewi, Muhammad S. Nur Zaman, Tika Arundina, and Wisam Rohilina. Imam Wahyudi Fenny Rosmanita Muhammad Budi Prasetyo Niken Iwani Surya Putri

About the Authors Imam Wahyudi is a lecturer at the Faculty of Economics and Business, University of Indonesia (FEB-UI). As an assistant professor, he is currently teaching Islamic finance, risk management, mathematics of finance, and corporate finance. He is also a senior researcher at the Centre of Islamic Economics and Business, with research inter- est on Islamic finance and institutions, risk management in Islamic banking and capital markets, market microstructure, and corporate finance. After earning his master’s of management degree at FEB-UI, he has published numerous papers and publications in national and international journals, and was involved in various projects with Bank Indonesia, Ministry of Finance, and the Indonesia Financial Services Authority. Fenny Rosmanita is a lecturer at FEB-UI. She is currently teaching statistics for economic and business, mathematics for economics and business, Islamic economics, macroeconomics, Islamic banking funding, Islamic banking, and business operations. She is also a researcher in the Centre of Islamic Economics and Business at FEB-UI, with research interest on the area of Islamic finance and accounting, as well as zakah and awqaf management. She obtained her bachelor’s degree in economics from the Department of Eco- nomics at FEB-UI and her master’s of management on Islamic business and finance from the University of Paramadina, Jakarta. Muhammad Budi Prasetyo is a lecturer and a junior researcher in the Department of Management at FEB-UI. His research areas are finance and banking, especially Islamic banking. He attained his bachelor’s degree from the Department of Management at FEB-UI in 2007, and gained his master of science in management with specialization in finance and banking from the graduate program in management science (2011). xxiii

xxiv ABOUT THE AUTHORS Niken Iwani Surya Putri is a lecturer at FEB-UI. She is currently teaching risk management, corporate finance, entrepreneurship and manage- ment studies. She is also a junior researcher at the Centre of Islamic Economics and Business. Her research interests are in the area of Islamic microfinance, Islamic nonprofit institutions, consumer behavior, and entrepreneurship. She obtained her master’s degree in economics and business at Erasmus University in Rotterdam.

List of Acronyms 5C character, capacity, capital, collateral, conditions AAOIFI Accounting and Auditing Organization for Islamic Financial ACT-1 Institution AMA Additional Capital Tier 1 AMBD advanced measurement approach ANZ Autoriti Monetari Brunei Darussalam APT Australian and New Zealand Standard ASA arbitrage pricing theory BCBS alternative standardized approach BI Basel Committee on Banking Supervision BIA Bank Indonesia BIS basic indicator approach BMT Bank for International Settlement BNM baitul maal wa tamwil CAD Bank Negara Malaysia CAMEL capital adequacy directive capital adequacy, asset quality, management quality, CAPM CAR earnings, liquidity, sensitivity to market risk CCB capital asset pricing model CDO capital adequacy ratio CDS countercyclical buffer CDF collateralized debt obligation CET-1 credit default swap CFaR cumulative distribution function CFO Common Equity Tier 1 CMT cash flow at risk CRI chief financial officer CRO commodity murabahah transaction CRR composite risk index COSO chief risk officer cash recovery rate Committee for Sponsoring Organizations xxv

xxvi LIST OF ACRONYMS CRI composite risk index EaR earning at risk ERM enterprise risk management EVA economic value added EVT extreme value theory FAS Financial Accounting Standard FDR financing to deposit ratio GCC Gulf Cooperation Council GDP gross domestic product GSIFI Governance Standard for Islamic Financial Institution IAH investment account holder IAS internal accounting standard ICAAP internal capital adequacy assessment process ICMA International Capital Market Association IFSA Indonesian Financial Services Authority IFSB Islamic Financial Standard Board IFRS International Financial Reporting Standard IIFM International Islamic Financial Market IIMM Islamic Interbank Money Market IMA internal model approach IMBT Ijarah mumtahia bi tamlik IMF International Monetary Fund IRB internal ratings-based IRC incremental risk charge IRR investment risk reserve ISO International Organization for Standards KIBOR Karachi Interbank Offered Rate KYC know your customer LCR liquidity coverage ratio LFHS low frequency high severity LGD loss given default LIBOR London Interbank Offered Rate LMC Liquidity Management Center LTCM Long Term Capital Management MAS Monetary Authority of Singapore MII mudharabah interbank investment MPO murabahah purchase order MSME micro, small, and medium enterprise NPF nonperforming financing NSFR net stable funding ratio

List of Acronyms xxvii OIC Organization of Islamic Cooperation OECD Organisation for Economic Co-operation and Development PD probability of default PDF probability density function PDCA plan – do – check – act PER profit equalization reserve PLS profit and loss–sharing PMI Project Management Institute PSIA profit sharing investment account RAROC risk-adjusted return on capital RAPM risk adjusted performance model RMC risk management charter ROE return on equity RWA risk-weighted assets SA standardized approach SAC Syari’ah Advisory Council SBI Sertificate of Bank Indonesia SME small and medium enterprise SPV special purpose vehicle SSA simplified standardized approach SVA shareholder value added TBTF too big to fail TCTF too connected to fail TMTF too many to fail UL unexpected loss VaR value at risk

PART One Introduction Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East. Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo, Niken Iwani Surya Putri. © 2015 by John Wiley & Sons Singapore Pte. Ltd. Published 2015 by John Wiley & Sons Singapore Pte. Ltd.

1CHAPTER Principles of the Islamic Financial System Islamic finance is an integrated social, economic, and financial system based on a set of principles that brings a positive motive for economic activ- ity, balanced between material and spiritual needs and between personal and societal interest. Among those principles are balance between work and reward, equal treatment of humans, responsibility over self and society, fair- ness in scale and measurements, the principle of coexistence, prioritization of the interest of other people and society over one’s self-interest, and freedom of conscience. The initial purpose of the modern financial industry’s intermediation is to assist the economy and from it the distribution of resource within society. But then, this purpose encounters obstacles in the form of “bourgeois appetites,” democratic politeness, and individual work ethic. These three forces cause humans, as economic agents, to never be satisfied with the resources that they already own, and propel the mechanism of finan- cial manipulation to create “high-powered money,” ending in excessive risk-taking behavior. The combination of these three powers supports the idea of individual freedom and achievement, but abandons the idea of the economic agent’s part in social responsibility. Islam recognizes the three powers as nafs, a catalyst for economic activity and the progress of civilization that can only aid in achieving prosperity when coupled with institutional reform and a mechanism to check the morality of the actions of humans in its execution. Islamic financial institutions arise as entities that are trusted to have a strategic function for institutional reform in the direction of prosperity as well as priority in the real sector, complemented with an ethical oversight mechanism through syari’ah principles that grounds operations and transaction activity. ISLAMIC FINANCIAL CONTRACTS: THE LI-TABARRU’ CONTRACT VERSUS LI-TIJARI CONTRACT Based on the purpose or reason of a contract’s formation between two peo- ple or more, financial contracts can be divided into three. First is the contract Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East. Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo, Niken Iwani Surya Putri. © 2015 by John Wiley & Sons Singapore Pte. Ltd. Published 2015 by John Wiley & Sons Singapore Pte. Ltd. 3

4 INTRODUCTION for the purpose of generating profit, called li-tijari. Every party in the con- tract is aware that they or their cosigners enter into the contract for the purpose of acquiring personal gain for themselves through the contract. Usually there is a bargaining and negotiating process, either bilaterally or multilaterally, on the specifications of the contract, such as the terms for price, quality, and quantity of the object; the ratio; the timeframe of set- tlement; the time of delivery; the time of payment; and the like. With this awareness, all sides have willingly accepted the risk inherent in the contract and have no regrets if the realization of the contract is different from their expectation. In mu’amalah, there are many examples of this sort of con- tract, like sale (bay’), rent or lease (ijarah), partnering in business (syirkah), the cultivation of agriculture (musaqat), and so forth. Islam allows anyone to enter a transaction with the intention of gaining profit as in the various contracts mentioned, as long as the contracts are made properly and are also executed properly. The profits gained from these contracts are incomes that are lawful and good, for they are gained by the efforts of one’s own hand. Second is the contract that is made with the purpose of giving reward, aid, or assistance to other people; this is called the li-tabarru’ contract. This type of contract is usually entered by those who are in need, have lived through a catastrophe, or are under problems that cause them to need the assistance of others. In this contract, negotiation or bargaining is rarely found except in payment terms and due date, where both are related to the ease preferred by the party in need. Because of this, Islam loathes anyone who exploits the opportunities that arise from other people’s needs for per- sonal gain or profit, material or immaterial, through any assistance rendered. Among the examples are loan or debt (qardh), entrustment (wadhiah), repre- sentation (wakalah), borrowing or lending (dayn), transfer of debts between debtors (hawalah), etc. In qaidah fiqhiyah, it is said, “every loan receivable that generates benefit/gain, then it is usury” (Asy-Syairazi, Al-Muhadzdzab: 1/304). Included in this group of contracts is a contract of guarantee over debts or loans, like third-party guarantees (kafalah) and asset-backed guar- antees (rahn). It is hoped that by knowing the division of financial contracts and by executing them consistently, one can avoid various forms of usurious trans- action. For example, when one is interested in helping others who need capi- tal for business, but is still at the same time interested in turning a profit, then the li-tijari contract can be used, like murabahah or ijarah. In both of these contracts, the capital owner can receive profit in the form of sales margin or rental fee, and the entrepreneur receive working capital in the form of fixed assets without having to expend money at the beginning. Other than that, by understanding the purpose for financial contracts, the parties involved can realize their position within the contract and their rights and responsibilities.

Principles of the Islamic Financial System 5 PRINCIPLES OF ISLAMIC FINANCE Risk sharing as a principle of justice is embodied in Islamic economy. Every economic agent involved in financial transactions, consciously or unconsciously, directly or indirectly, should complement each other and the system. All parties, without exception, can access money and other resources in the economy. The result is a “multiplier effect” that appears to drive the economy and improve the welfare of the community, not just the individual. All of these are summarized into three Islamic finance principles: universal complementarity, justice and equity in al-hisba, and abolition of riba. Universal Complementarity Both conventional and Islamic financial institutions function with the pur- pose of creating a system to enhance the efficiency of resource allocation and distribution in society by providing financial services to bridge the gap between the parties with excess funds on hand and those needing funds, thus setting in motion continuous economic growth. The basic difference between the two is that an Islamic financial institution must be free from all forms of usury, gambling (maysir), uncertain or doubtful elements (gharar), swindling (tadlis), injustice and coercion (ikhraha). Islamic financial institu- tions divide risk and profit fairly between different economic actors, both when there is a surplus of funds as well as when there is a deficit of them. This division of risk is a manifestation of the principle of economic fairness and implemented among the participants in the profit–loss sharing scheme. Every economic agent involved in a financial transaction, aware or not, directly or indirectly, should complement each other’s absence of skill or function. Thus, everyone, without exception, can access the money in circu- lation and the available resource. Of course the multiplier effect that can be generated will mobilize the economy and improve the society’s prosperity, not just the individual ones. When every element in the society is considered as an economic agent (producers and consumers, government, households, and industry) with complementary functions needed to achieve societal pros- perity, the loss of individual business opportunity is a loss to society. Justice and Equity in Al-Hisba Among Islamic financial contract schemes, the profit-sharing instrument is considered to be most representative of Islamic finance’s character. This scheme is dependent on the proportion (nisbah) agreed upon, based on the comparison between the opportunity cost of capital and the expectations of profit or loss of business. In Islamic finance, pricing is not determined

6 INTRODUCTION by conventional standards (e.g., the capital asset pricing model [CAPM], market interest rate, etc.), but from the comparison of the function of satisfaction of capital to individual satisfaction and, on an aggregate level, a comparison to the economic surplus of every economic agent. Abolition of Riba Other than the two principles, there is at least another that must hold in the implementation of Islamic finance; the principle of removal of usury (riba). It must be understood that the marginal rates of substitution will be different among economic agents. This difference should be reflected in the lack of a “unified interest rate” as a reference for opportunity cost. In the allocation of return, it should be based on the division of investment roles along with the risk distributed among them. With that, every business opportunity will have a unique rate of return. In the end, this practice will consistently move in the direction of the removal of usury, which is the removal of a predeter- mined rate of interest between economic agents. In other words, economic agents will share risks and returns based on the actual performance of an investment. Aside from the way that usury is a form of injustice and is as such unlawful in Islam, the removal of usury is an implementation of the principle of fairness in measurement or scales. Every economic agent receives a dif- ferent return according to their own measure, dependent on the investment role and risk that they’ve taken. INTEREST-BASED RETURN VERSUS PROFIT–LOSS SHARING In Islamic finance, money is only considered as a medium of exchange and does not have intrinsic value on its own; because of that, if the money is idle (left in the bank or lent to other people) and not used in business, then money should not increase. On the other hand, Islamic finance considers that the human endeavor, initiative, innovation, creativity, and risk inherent in productive business are more important than the money used to fund the project itself. Money is considered capital only if it is invested in business and the investors accept the possibility of loss or failure in business; thus, investment also opens the possibility of growing. If the money is given to a business in the form of a loan, instead of equity, then because it is debt instead of capital, the money has no right to any return generated by the business (like interest). This is because money only has a time value when it is invested as capital, not when it is idling as “potential capital.” Besides, Islam does not consider loan (or debt) as an income-generating transaction.

Principles of the Islamic Financial System 7 Money, Time Value of Money, and the Discounted Model in Islam Islam forbids the practice of usury in all its forms, such as a discounted debt (borrowing $1,000 for a period of 3 months, but the money received at the beginning is only $950, and the borrower is required to return exactly $1,000 at the due date), an interest-bearing debt (borrowing $1,000 for three months with an interest rate of 12% per annum, thus accepting $1,000 in cash at the beginning and being required to return $1,030 at the end of the three month period), or a return for the due date extension (borrowing $1,000 for three months, without interest, and receiving $1,000, but failing to pay at the due date; the lender extends the due date and asks for an addi- tional payment or late payment penalty of 0.01% per day of delay). This prohibition of usury emphasizes that it is not allowed to apply an indexing method or a discounted model in the case of a debt or loan contract. On a debt-based sales contract, it is allowed in Islamic finance to set a price that is different from the current market price; a mu’ajjal contract uses a price that is higher than the current market rate (at premium), and a salam contract uses a price that is lower than the current market rate (at discount). Indirectly, Islamic finance accepts the possibility of price different between immediate cash payment and those where the delivery of goods and the delivery of the payment do not coincide in timing; this is an example of the existence of time value of money for the deferral of cash acceptance or goods acceptance. When the price is determined at the beginning of the con- tract, the profit margin can be immediately recognized, and as long as there is no defaulting payment, then that is also the amount of profit that will be realized. Considering the way price and margin are formed, this mu’ajjal contract is similar with discounted debt. The difference in discounted debt is that in a pure debt (li-tabarru’ contract), there are no goods or services that needs to be delivered to the borrower (except for money), because accord- ing to the syari’ah the lender has no claim over the difference of what is paid and what is accepted without bearing a part of the risk (other than the risk of default). While in a mu’ajjal contract, the seller transfers the goods to the buyer, where previously the seller must hold the goods and thus bear the market and product risks, and for that cause, according to the syari’ah, the seller has the right to claim the difference between the sale price and the cost of goods sold as profit margin. Risk-Free Assets in Islamic Finance Risk-free assets imply that the asset will still give a positive return to its holder, no matter the business condition that has befallen on the firm that issued it, regardless of whether it has succeeded or failed. Other than that,

8 INTRODUCTION an asset is said to be risk-free if the return that it generates is constant and invariant through time. This term is better known from the CAPM, where the risk-free asset is associated with the opportunity cost borne by the investor when the investor takes additional risk in a project. The investor requests additional return as a compensation for venturing beyond the status quo in placing his or her funds on financial instruments (assets) with a positive yield, and yet risk-free. Here, it is assumed that (1) money can generate real income from itself; (2) alternative projects always generate positive yield; and (3) there is no risk associated with alternative projects; and these three assumptions are frankly not true. Apart from opportunity cost, the concept of the risk-free asset also represents the decline of pur- chasing power caused by inflation. When there is a positive inflation, if the nominal amount of money does not increase, then within the year, the real value of the money will decline by the same amount as the inflation rate. This is why when investors decide to invest, there is a potential loss if the yield of the project is smaller that the ongoing rate of inflation. There are three possibilities of implementation of the concept of risk-free asset: qardh (loan or debt), debt-based sale contract (salam or mu’ajjal), and partnerships or syirkah (mudharabah, musyarakah). In the first case, the application of the concept of the risk-free asset will cause the payment of debt to be larger than what is received by the borrower. For whatever rea- sons, whether due to opportunity cost or compensation over the effects of inflation, this nominal addition to the future value is not allowed in Islam, and falls under usury. In the second case, the concept of the risk-free asset is used to determine the size of the margin in a mu’ajjal sale or the discounted price in a salam price, and this is allowed in Islamic finance. In the third case, the application of the concept of risk-free asset is only allowed as a bench- mark and cannot be set as a predetermined rate of return. This concept can only be used to simulate the ratio for the preferred rate of return and esti- mate the yield with that ratio. But, after the ratio is set, the realization of the return will rely on the realization of the profit or loss of the business. Thus, different from the second case, on syirkah, the application of the concept of the risk-free asset is abstract and not real.

2CHAPTER The Islamic Bank and Risk Management The Islamic bank is a financial intermediation institution, bridging a deficit sector in funds with one that experiences a surplus of funds. Conceptually, a bank is a win-win solution not only for the surplus sector and the deficit sector, but also for the bank facilitating the needs of the two. This concept is in line with the concept of transaction within Islam; that all mu’amalah transaction began from the intent of mutual assistance (at-ta’awun), and to spread good deeds among men. The party with the surplus funds benefited from the security provided by the bank (wadhiah-based product) or from the returns of the invested funds (profit-sharing–based product). The party with the fund deficit benefited from the needed financing assistance. In Islamic finance, Islamic banks are not only expected to be able to fulfill their function as a financial intermediary optimally, but also to fulfill a wider function. The Islamic bank should be able to mobilize the economy by channeling funds that would otherwise lie idle from the surplus sector to business and economic actors in order to support production, distribu- tion, and consumption functions within the society. With this approach, economic benefit will be experienced by all members of society, not only among the richest layers but also by those in need of working capital; this increases the multiplier effect as the gears of the economy move. The function of ‘adalah (fairness) can only be manifested as closely to the ideal as possible if Islamic banks not only act as a “dumb pipe” that funds enter and exit passively, but also involve themselves actively in real economic activities. Other than the economic-profit dimension, Islamic banks should also encourage various business activities and operations toward a social dimen- sion; this is beyond just executing a social responsibility function. An Islamic bank is encouraged to accept and distribute social funds, like zakat, infaq, and alms (shadaqah), to parties who need them. Islamic banks may have ended up only channeling these funds to fund the consumption function of the poor and needy, in which afterward the funds will be depleted there, Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East. Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo, Niken Iwani Surya Putri. © 2015 by John Wiley & Sons Singapore Pte. Ltd. Published 2015 by John Wiley & Sons Singapore Pte. Ltd. 9

10 INTRODUCTION without the ability to generate a new cash flow for the poor or to increase their income capacity. Even then, that is enough for the bank to be said to have fulfilled its social function. DIFFERENCES BETWEEN AN ISLAMIC BANK AND A CONVENTIONAL BANK The concept of Islamic banks exists in the middle of the frenetic pace of conventional banking practice, in which these two business entities have different principles. In fulfilling the intermediation function, conventional banks use as a basis the interest rate, both from the asset side and the liabil- ity side. Because syari’ah prohibits the application of interest, various modes of financial transaction not involving interest were developed. This prohi- bition of interest is comprehensive in nature, covering funding, financing, products, and services. This interest system is replaced with a profit–loss sharing system. This profit-sharing system is applied in investment contracts (i.e., mudharabah and musyarakah). On the funding side, conventional banks reward depositors with a cer- tain level of interest, and thus the return of the funds kept is already pre- determined at the beginning of the contract. This is different from Islamic banks, which reward depositors based on a ratio (nisbah) predetermined at the beginning of the contract between the bank and depositor. As the return is divided according to the profit received by the bank during the investment period, the precise amount cannot be predicted beforehand. For products of credit or loan, conventional banks use interest-bearing instruments to channel third-party funds. In channeling third-party funds in the form of financing, Islamic banks can use a profit-sharing system, asset leasing, or sale-based contracts. In a profit–loss sharing system, other than sharing profit based on an agreed-upon ratio (nisbah), there is also a sharing of risk. This is different from methods involving the conventional bank, in which the whole loss is borne by the entrepreneur or borrower. An Islamic Bank Deals in Real Goods or Services, Not in Money According to an Islamic perspective, money functions only as storage of wealth and a medium of exchange, not as a tradeable commodity. Because of this, Islam prohibits the sale of money with money in deferred pay- ment/goods delivery, because this is part of usury. Money cannot be sold for a profit. With the lack of interest over loans, Islam offers a solution in the form of interest-free financial products. The transaction can be in the form of sales, profit sharing, or leasing. In sale contracts, the goods sold are real goods.

The Islamic Bank and Risk Management 11 In a profit-sharing contract, the business receiving the financing should also produce real goods and services and have viable future prospects. Even more important is to change the paradigms of the bankers; in conventional banking methods, the bankers only consider how to locate prospective financing payments, finance those proposals, and ensure that the bank’s funding channeled by the bank will be returned along with a predetermined rate of return. When a proposal is approved and funded, the bankers are more focused on capital recovery than on ensuring that the debtors’ businesses have developed according to their expectations. Why does this happen? Because the success of the debtors will not impact the return that they will receive; the bankers will only receive the return in terms of the interest rate that is predetermined at the beginning of the contract. Because of this, the bankers have no real incentive to help develop the debtors’ businesses. The bankers’ only concern is in recovering the principal of their loan along with its interest. They only enter into an assistance process and intensive oversight when any of the debtors’ businesses experience trouble. Once more, the motivation here isn’t to ensure the debtors’ businesses overcome their troubles and experience success, but only to ensure the return of the bank’s capital and its interest. This way of thinking is one that should be eliminated once a banker has crossed over (hijrah) to the Islamic banking system. The same beneficial effect to society should also apply to lease contracts: the object being rented should be a real object and capable of being handed over. The renter receives benefit (usufruct) from the object being rented. In Islamic finance, the ijarah contract (leasing) entered into by the bank can only be of the form of operating lease, not of capital lease. With regards to the asset, the bank can either own the asset whose benefit (usufruct) will be rented out, or the bank could enter into an ijarah contract with the first party, to then rent it out to the second party (this is called a parallel ijarah) as long as the first party does not stipulate that the asset cannot be entered into a second ijarah contract. HISTORY OF THE ISLAMIC BANK An early experiment in modern Islamic banking was initiated by Abdul Aziz Ahmad El-Najjar through Myt-Ghamr Bank, established in 1963 in Egypt. With assistance in capital from King Faisal of Saudi Arabia, the Myt-Ghamr Bank was considered successful in combining German banking management with Islamic finance principles and translating that into banking products that are suitable for rural areas mostly oriented toward the agricultural industry. Due to political reasons, the Myt-Ghamr bank closed in 1967.

12 INTRODUCTION Initial ideas on the establishment of Islamic banks internationally began in an OIC conference in Kuala Lumpur in 1969. The participants agreed on several things, the first being that every profit must be based on the principle of profits and loss sharing, and if not, the profit would fall under the cate- gory of usury, which is prohibited in Islam. Secondly, it was recommended that an Islamic bank free from the usury system be established quickly, and that in the interim, before the establishment of such a bank, the conven- tional banks would still be allowed to operate as long as it were a matter of emergency. Based on the recommendations from the Islamic Economy Con- ference in Mecca, the Islamic Development Bank (IDB) was established in 1975. IDB had an important role in fulfilling the financing needs of Islamic countries to build infrastructure and actively provide with an interest-free guarantee based on the country’s capital. The establishment of IDB also motivated many other countries to establish Islamic financial institutions. The first Islamic bank established was a private one. Built by a group of Muslim businessman from various countries, the Dubai Islamic Bank was established in 1975. In 1977, two more Islamic banks were established: Faysal Islamic Bank in Egypt and Sudan, and Kuwait Finance House estab- lished by the Kuwaiti government. Bahrain Islamic Bank was established in 1979. Philippine Amanah Bank was established in 1973, based on a presi- dential decree, and Muslim Pilgrims Savings Corporation was established in 1983 in Malaysia. At the beginning of the 1980s, various countries hosted emerging Islamic banks of two general types: Islamic commercial banks and Islamic investment institutions. GLOBAL ISLAMIC BANKING ENTITIES The banking system in a country could not stand alone only by relying on banking institutions and regulators in domestic level. There are some orga- nizations at the global level that have roles in providing guidance regarding best practices for the banking industry and regulators in every country. It also applies to Islamic banking, for which there are some global organiza- tions such as IDB, IFSB, and AAOIFI, and other organizations that have different roles and functions. Those organizations synergize to maintain the banking practice so that it still runs in accordance with syari’ah principles and good governance. Islamic Development Bank (IDB) IDB is an international financial institution established to follow-up on the results of the conference that finance ministers from various Islamic coun- tries held at Jeddah in December 1973. Based on the results of the meeting

The Islamic Bank and Risk Management 13 of the Board of Governors on July 1975, the IDB was officially in opera- tion on October 20, 1975. The purpose of the establishment of the IDB was to assist the social and economic development of its member countries and Muslim society, according to Islamic principles. IDB also provided loans and capital for projects and productive enterprises, as well as financial assistance to member countries in other forms for the purpose of social and economic development. IDB was given the authority to receive deposits and to mobilize financial resources through the appropriate Islamic mode. Other than that, IDB was also responsible for assisting international trade promotions, espe- cially for capital goods, among the member countries; providing technical assistance for member countries; and providing training facilities to support the development of the application of Islamic principles in Muslim countries. Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) The AAOIFI was established in 1990; it is an independent, international organization supported by 200 member institutions from 45 countries, cov- ering central banks, Islamic financial institutions, and other financial institu- tions in the Islamic banking and finance industry. As of this writing, AAOIFI has already published 50 standards for accounting, auditing, ethics, and other syari’ah standards. Even if they are not binding, with the publication of the standards it is hoped that all Islamic financial institutions and reg- ulators managing how Islamic finance is practiced in each countries apply a uniform standard. The purpose of the establishment of AAOIFI was to develop accounting, auditing, governance, and ethics for various activities of Islamic financial institutions to make sure that they are in accordance with Islamic principles as well as international standards and practices; to reconcile accounting procedures and policies used in Islamic financial insti- tutions with the same standards and interpretations used in their conven- tional counterpart; and to issue a syari’ah standard in relation to the concept and application of a syari’ah supervisory board in each Islamic financial institution to prevent contradiction and inconsistencies between fatwas and their application. Islamic Financial Services Board (IFSB) The IFSB is an international organization drawing up the principles, guidance, and standards in the banking, insurance, and capital market sectors with the purpose of supporting stability within the Islamic financial industry. IFSB concentrates on the establishment of risk management, cap- ital adequacy, corporate governance, and transparency standards, as well

14 INTRODUCTION as market discipline for Islamic financial institutions. IFSB was established in November 2002 and started operating in 2003; it is headquartered in Kuala Lumpur, Malaysia. IFSB is the result of a long and extensive consultative process that lasted more than two years between the governors and senior employees of central banks and monetary authorities of various countries, with support from IDB, the International Monetary Fund (IMF), and AAOIFI. The purpose of the formation of IFSB is to develop a new standard or adopt an existing one and give a recommendation on how to implement it; to provide an effective guide on effective governance and supervision; to establish cooperation between international standard-setting bodies with its member countries; to improve and coordinate the initiative in developing instruments and procedures; to develop instruments and pro- cedures for the efficient management of risk and operations; to encourage cooperation between member countries; to facilitate capacity-building and the development of human capital; to research Islamic financial institutions, as well as publish the results of such studies and surveys; and to build a database of Islamic financial institutions and banking, as well as expertise in the industry. Fatwa Committee in International and Domestic The development of Islamic banking cannot be separated from the role of the fiqih-experts (ulama) in issuing fatwa or opinions with regards to products, procedures, and operations that are in accordance with the syari’ah princi- ples. There are some differing schools in the application of Islamic syari’ah, and this may give the impression that some of the fatwas issued contradict each other. To address the problem, the Islamic Fiqh Academy was estab- lished on January 1981 in Jeddah, supported by the Organization of Islamic Cooperation (OIC) as an international conduit for countries with a Mus- lim majority. The Islamic Fiqh Academy published various guides on moral issues; included within those are medical ethics, socioeconomic issues, and problems like finance. In the economic field, this fatwa committee will pub- lish rules (that are called fatwa) so that the product and the operations of an Islamic bank are in accordance with the principles of the Islamic syari’ah. Other than on the international level, every country also possess a fatwa committee that is usually called the National Syari’ah Board. This national fatwa committee has a prerogative right in deciding on a syari’ah compliance issue or independent fatwa; the regulators do not intervene and leave to the market with regards to the how syari’ah-compliant as well as the integrity of the process. The National Syari’ah Board performs its duty assisted by the Syari’ah Supervisory Board. The main responsibility of the Syari’ah Super- visory Board is to study fatwa, to oversee banking activity, to ensure that

The Islamic Bank and Risk Management 15 the operation of Islamic banking is in accordance to syari’ah rules, to issue fatwa related to banking operations and financial transactions, and to ensure that the fatwa is binding for all of the Islamic banks that are its members. The other responsibility of the Syari’ah Supervisory Board is to assist the bank in determining which accounting policy to adopt, how to determine the profit-sharing ratio between the bank and the customer, how to deter- mine the calculation and payment of zakat, and how to determine the income that is distributed and the cost (windows) that is charged. Single versus Dual Banking System The dual banking system is a set of systems, rules, and applications for the Islamic financial industry that run in parallel with those of conventional banking. There are several reasons why several countries apply a dual bank- ing system through the use of Islamic banking windows. The first reason is about gradual implementation: It takes time to build a customer base, edu- cate the public, change the regulatory environment, develop the capability of the human resources, and build adequate infrastructure. The second reason is related to efficiency. Acquiring the various prerequisites needed to develop Islamic banking requires not only time, but also cost. Using the shortest amount of time possible and the lowest cost, an Islamic banking window is far more profitable than establishing a full-fledged Islamic bank. By enacting an Islamic banking window, an established bank can ensure that the use of infrastructure and human resource allocation in its efforts are as optimal as possible and prevent avoidable duplication of resources. The third reason is effective development. The Islamic banking industry can instantly increase the number of players as well as fund-gathering capabilities, provide product variations, and increase the performance of Islamic banks along with the increase of competition in the industry. With the wide and well-established network of a parent conventional bank, the Islamic window can hitchhike the marketing network of the parent com- pany and mimic the products of the parent bank that are already popular in the general public and can be adjusted to become syari’ah compliant. The fourth reason is the benefit of a well-established technology and system from the parent conventional bank, in the form of standard operating procedures, information systems, control and monitoring systems, as well as information related to the database of existing customers. The fifth reason is the possibility to capture the non-Muslim segment of the market as well as the floating customers. Even if it is more practical to use an Islamic banking window, some coun- tries prefer that Islamic banks do not develop from the Islamic windows of a conventional bank, but directly in the form of a full-fledged Islamic bank.

16 INTRODUCTION This policy of course necessitates the consideration of several things. First, the new Islamic bank must ensure the syari’ah implementation of an its oper- ations in all aspects, including the prevention of the intermixture of funds with the usury-based conventional bank and the prevention of conflicts of interest in management goals and organizational barriers. Second, for the regulator, it is easier to compare the performance between the two insti- tutions, to regulate and ensure that the syari’ah requirements are fulfilled. Third, it preserves the essential idea and image of Islamic banking and to attract international investors, especially from the Middle East. Fourth, in the perspectives of an economic system, a full-fledged Islamic bank creates many new jobs as it proceeds to find people with the relevant, specific knowl- edge and competence to fill the ranks of its employees and management. RISK AS AN INTEGRAL PART OF ISLAMIC BANK Risk can be defined as the consequence of a choice that contains uncertainty, with the potential to generate an unwanted result or other negative conse- quence experienced by the decision maker. From that definition, risk has several dimensions: opportunity cost, potential loss, uncertainty, and receiv- ing a result that is not as expected. Risk is also not related to the size of the cost that has to be borne by an individual or institution. In risk manage- ment terms, those expenses are expected loss or cost. The real sorts of risk are expenses that occur suddenly through unexpected ways, directly erod- ing the wealth that was previously accumulated. Both terms, expected and unexpected losses, are two important concepts that are often used in apply- ing risk management, especially in relation with measuring every sort of risk. Most people are able to identify, estimate, calculate, and mitigate expected loss, but fail at anticipating unexpected loss. Events causing unexpected loss happen rarely, but once they happen, the magnitude of the negative effect is large and can cause a large loss. Rare events causing unexpected loss are usually considered unthinkable before they happen. In many literatures, risk is often defined more precisely. For example, risk is the volatility of net cash flow of business (or department in the bank, loan portfolio, single debtor, or even the bank as a whole). With that definition, risk is often measured by standard deviation. If we apply this to the context of the cash flow of the bank, the higher the standard deviation of the bank’s cash flow, then the wider the spread of the cash flow values from the bank’s average cash flow. As a consequence, the bank will often face conditions where the cash flow is outside the average; it can be larger or smaller. Thus, the higher the standard deviation of the bank’s cash flow, then the higher the degree of uncertainty of the bank’s possible cash flow.

The Islamic Bank and Risk Management 17 Risk: Imperfect Information, Uncertainty and Gharar Risk begins from imperfect information in various decision-making aspects as well as their results: “Risk comes from not knowing what you are doing.” This information imperfection will bring about uncertainty. There is always a degree of uncertainty in living in the world, as no one knows for cer- tain what will happen tomorrow. There are no guarantees that our efforts (ikhtiar) will always bring us profit. Before any event happens, what exists is mere uncertainty. With this understanding, then, these words are very true: “Risk is Allah Ta’ala’s fate, and only Allah Ta’ala knows what will happen tomorrow.” Each person need to realize that risk and the uncertainty feeding it are part of Allah Ta’ala’s secret. Perfect information is not achievable for any mortal and belongs only to Allah Ta’ala. In Islam, the closest term to this condition of imperfect information is gharar. The condition of imperfect information can emerge naturally with- out any actual intention from the parties in the transaction. This is the definition of gharar. If there is an intentional element causing the uncertainty from one or more of the parties manipulating information or hiding it, then this is called fraud (tadlis). Islam prohibits the presence of gharar and tadlis in a transaction. Natural risk refers to gharar that is minor, easily ignorable, and still attached to the contract, even after one try to alleviate it, and further efforts to alleviate it will only bring a greater cost than the possible cost of leaving the gharar in the contract. But if the gharar itself is major and can be alle- viated, and yet is left in a contract on purpose, then this falls into synthetic risk. Synthetic risk happens when various principles and terms of making a contract according to syari’ah are not fulfilled. As such, this definition of risk is closer to syari’ah compliance risk. Risks Faced by an Islamic Bank The Islamic bank is a financial institution receiving profit from its successes in bridging different liquidity and risk profiles within the public and between parties with surplus funds and deficit in funds, while converting risk into return. The risk that is faced by the Islamic bank is varied and complex, as are the innovations in the financial and banking products that they offer to the public. Credit Risk Terminologically, it is more appropriate to use the term credit risk in a conventional bank. The term credit risk is generally used for interest-bearing loans. The more accurate terminology in Islamic banks is financing risk, because it covers the risk in various other forms of financ- ing contracts, like interest-free loan (qardh), sale-based contract (salam,

18 INTRODUCTION murabahah, istishna’), and lease-based contract (ijarah). Traditionally, what is meant by credit risk is the risk that emerges because of the failure of the customer or other parties to fulfill their liabilities to the Islamic bank according to what is already contracted. This failure in payment/default can be caused by two things: the inability to pay, or the unwillingness to pay the defaulted loan. In various risk management literature, this risk is also called default risk, financing risk, rating downgrade risk, and contract completion risk. Market Risk Market risk is the risk that occurs from adverse market move- ment, for example, in the stock price and sukuk price, commodity price, and foreign exchange value of the various assets held in a portfolio by the Islamic bank; this can of course, cause actual loss. This risk only occurs when the bank holds the asset, but not to be owned or held until its maturity period is up, but to resell at some time in the future. Generally, the coverage of market risk included exchange rate risk, commodity price risk, and equity price risk as well as benchmark rate risk. Liquidity Risk Liquidity risk is the risk that emerges from the Islamic bank’s potential inability to fulfill obligations that have reached their maturity date. This risk occurs as a consequence of the temporal mismatch among the sources of the bank’s funds, the third-party funds, and the financing con- tract to the bank’s various debtors, especially if the financing done by the bank often defaults or experiences returns that are less than what is initially expected. Often the main trigger of bankruptcy experienced by banks, both large and small, isn’t from the losses they experienced, but due to the inability of the banks to fulfill their liquidity shortage. Operational Risk Operational risk is the risk of loss that is generated by inadequate internal control systems, the failure of internal processes, human error, system failure, and/or the possibility of some external events that can disturb the bank’s operations. An Islamic bank can also fail to follow the rules and principles of Islamic syari’ah, and this falls under the category of compliance risk. Business risk is often included in the category of operational risk. Counterparty risk embedded in financing risk where the involvement of every party—the Islamic bank itself, buyers, renters, business partners, suppliers, and the like—can also cause operational risk. Legal Risk Legal risks occur from the possibility of a lawsuit and/or a weak- ness in the judicial aspects of some of the bank’s operations. Some experts place legal risk in operational risk because lawsuits usually accompany failure or weakness in a written contract. Some of the ways this risk can manifest, among others, are through a filed lawsuit and the absence of laws

The Islamic Bank and Risk Management 19 and regulations particular to the contract, or any weakness in the contract, like the failure to fulfill the validity requirements of a contract, or imperfect binding of the collateral. Reputational Risk Reputational risk occurs when the trust of the stakehold- ers in Islamic banks is reduced, which is caused by a negative perception toward Islamic banking. This risk occurs, among others, because of media coverage and/or rumors about Islamic banking that are negative in nature, along with Islamic banks’ ineffective communication strategy. Negative pub- lication toward one Islamic bank has the potential to smear the reputations of other Islamic banks, even if they aren’t involved in the stated incident or action, just by dint of association. Strategic Risk Strategic risk happens due to an Islamic bank’s inaccuracy in making and/or executing a strategic decision, as well as the Islamic bank’s failure to anticipate changes in the business environment, both internal and external. This risk emerges, among others, because the Islamic bank applied a strategy that does not align enough with the vision and mission of the Islamic bank, the Islamic bank did not complete a comprehensive strategic environment analysis, and/or there is a strategic plan mismatch between strategic levels. Other than that, strategic risk can also occur because of the Islamic bank’s failure to anticipate the changing business environment, such as technological changes, changes in macroeconomic conditions, dynamics of market competition, and policy changes of related authorities. Compliance Risk This risk occurs when the Islamic bank does not obey and/or does not comply with the rules and regulations that are in effect and with the principle of Islamic syari’ah that is manifested in the form of the syari’ah board’s fatwa. In addition to fulfilling all the regulations and rules that are in effect, like a conventional bank, an Islamic bank should fulfill the principles of Islamic syari’ah in their business activity. The Islamic bank should purely operate based on Islamic syari’ah. Rate of Return Risk Rate of return risk occurs due to changes in the rate of return paid by the Islamic bank toward its customers, which affect cus- tomer behavior. When placing their funds in an Islamic bank, the customer has expectations on the rate of return that he or she wishes to attain. The dispersion from expectation can be caused by internal factors, like a depre- ciation of the bank’s assets, a decrease in the bank’s profit–loss share from debtors, or an increase in defaulting debtors, as well as external factors, like the increase in the rate of return offered by other Islamic banks, the increase in interest rate in conventional banks, and an increase in inflation in the

20 INTRODUCTION market that the rational, strictly transactional investors will start to expect to get a higher rate of return. These changes in expectations of the rate of return can trigger the transfer of funds to other banks. Investment Risk This risk occurs as a result of the Islamic bank bearing the risk of the debtor’s business experiencing losses when the business is financed with a profit–loss sharing contract, like mudharabah or musyarakah. The investment risk is larger if the profit-sharing base used is operating profit or net profit of the debtor’s business. If the debtor’s business goes bankrupt, the Islamic bank can lose the principal financing channeled to the debtor. Fiduciary Risk Fiduciary risk is a risk that arises from the Islamic bank’s failure in fulfilling both an implicit and explicit standard that can be applied towards their fiduciary responsibility. Investment failure can cause the Islamic bank to experience bankruptcy (insolvency) in which it cannot pay back its third-party funds. AAOIFI categorizes a risk as a fiduciary risk if an Islamic bank provides a rate of return that is lower than the market rate and if the depositors interpret this low rate of return as being due to the Islamic bank making mistakes in managing their funds and to violations in the Islamic bank’s investment contract. STAGES IN RISK MANAGEMENT In facing risks, Islamic banks need to acquire various risk management methods as ammunition. This should be done from the very beginning, at the point of deciding on the risk management goals and strategy, as well as identifying, measuring, and mitigating risks; running supervision; and reporting the implementation of risk management that has been done. Risk management practices need to occur continuously, the same way that risks constantly change and grow in amount and variety. Risk management practices continuously experience changes from time to time. Classic risk management focuses in determining the risk limit while ensuring that the business run is still profitable. The cutting-edge practice of risk management ensures that the organization has achieved the expected risk-adjusted performance. The evolution that has happened in risk-management practices is not only in the context of concept and framework, but also covers methods, measurement, and risk mitigation. The evolution of risk management is illustrated in Figure 2.1. The current principles and methods of risk management have been used by many financial institutions and are claimed to be quite sensitive to risk. This progress is undoubtedly connected to the development of new methods

Transactional Integrated Strategic Islamic Syari’ah Risk is bad — focus is Risk is an expense — Risk is an uncertainty — Risk is an uncertainty — focus is on on transferring risk focus is on managing focus is on optimization optimization of “reward” from the risk risk and ability to respond that we bear and ability to respond Traditional Risk Management Advance Risk Management Syari’ah Risk Management • Negative construct • Proactive about preventing and reducing • Risk is in business, investment, or • Hazard-base risk identification and Controls risks one’s life • Compliance issues addressed separately • Safety and emergency management • Integrates claim management, contract • Risk is uncertainty of the future, it review, special event RM, insurance and can be not only negative but also handled separately risk transfer technique positive • Purchase insurance to cover risks • Risk not integrated or managed broadly • Cost allocation used for education and • Risk can be identified, measured, accountability and managed. across the organization • Risk manager is “insurance buyer” • Lower insurance costs (overtime) • There is always risk in all the ways • Morel collaboration — as business to get return. units are willing • Proactive: managing the risk, • Risk manager may be the risk owner increase the positive impact and reduce the negative one. FIGURE 2.1 The Evolution of Islamic Risk Management 21

22 INTRODUCTION in risk management, a more complete and informative database, and more advanced and well-developed information systems. But on the other hand, the types and forms of risk have also changed, along with the development of risk management practices. With those drastic changes, the probability of having a large risk exposure and having that risk actually manifest as a major problem can be reduced and avoided. The high degree of interconnection and interdependence between banks has changed the face of risk. Systemic risk, which was previously not well known, became a very popular concern after the global financial crisis of 2008. The term “too big to fail” which was often used before, has now been eclipsed by the term “too many to fail.” From the crisis itself, we can see that risk itself has changed into something more complex and multifaceted than before. Building Philosophy and Organizational Culture The process of risk management should begin by building organizational culture, instilling philosophy, and integrating an institution’s vision and mission into the existing system. Not only is it necessary to build physical risk management systems (e.g., socializing the jargon, the information system technology, standard operating procedures, reward and punishment systems, etc.), but also it is more important to build an awareness and culture of risk management. Each employee in an Islamic bank must be aware of and understand that risk is always with them, all the time. They need to be aware that no matter how small the risk they are exposed to, that risk is a liable threat not only to them, but also to the banks where they work. This could extend to the disturbance of daily operations, the losses experienced by a bank’s business, and even to the extent of threatening the bank’s continued operations. Building Organizational Structure Because risk management is a continuous management process, its applica- tion should be supported by a strong and effective organizational structure. An organizational structure supportive of the application of risk manage- ment does not merely form a risk management division or department. More than that, the risk management process should be arranged in a way that combines both top-down and bottom-up approaches. The responsibility and decision making related to risk-management should be formulated at every managerial level. The top-down and bottom-up approaches to the risk management of Islamic banks are done simultaneously and concurrently, as shown in Figure 2.2. In a top-down approach, the top management formulates the guidelines, policy, and strategy related to risk management. Included in this are risk

The Islamic Bank and Risk Management 23 Top-Down Syari’ah Bottom-Up Supervisory Strategic Risk Management Operational Risk Management Board Set Islamic syari’ah Assess syari’ah principle guidelines Board of compliance of Director risk management related to risk management practices • Review external Assess environment effectiveness of risk management • Set risk appetite and parameters • Determine strategic action points • Direct delivery of Risk • Consider strategic actions Committee completeness of identified risk and • Monitor key risk Business Unit adequacy of indicators mitigating actions • Execute strategic • Aggregations of risk actions exposure • Report on key Transactions, risk indicators identify, evaluate, mitigate, and monitor risks FIGURE 2.2 Top-Down and Bottom-Up Approaches limit, risk mitigation, risk-return profile, and the like. These formulations are then socialized comprehensively, from the highest echelons of top man- agement to the lowest level of the Islamic bank’s structural position. The bottom-up approach, on the other hand, is done as the Islamic bank runs its daily operations in a routine and contiguous manner. In transactions done by officers in various branches of the Islamic bank, spread throughout all regions, the first part of risk exists. Risk began with the existence of the transaction itself, as the risk-return profile for each transaction must be able to be accurately estimated. The types of transactions entered by the officers are of course different from one unit (departments or division) to the next. The simplest process of risk management usually consists of three stages: the guideline-determination process, the decision-making process and the monitoring process. In the guideline-determination process, certain guides and standards of risk management like the determination of risk limit, the delegation of tasks related to risk management, operational

24 INTRODUCTION standards, return benchmark, etc., is determined by top management. The guidelines that have been formed are then socialized to all components of various levels in the Islamic bank. After that, the decision-making process can be handled by various components in the Islamic bank’s structure. Many decisions that are directly related to risk are decisions that are related to banking transactions. Finally, all risks that emerge from various financial transactions must always be monitored and supervised to ensure that infor- mation related to the risk exposure of the Islamic bank is always up-to-date. The monitoring process can function as an early warning system. If there is a transaction whose risk contribution can drastically increase the risk exposure of the Islamic bank, then a good monitoring process should be able to detect this as it happens, enabling timely prevention or mitigation. Preparing an Adequate Database System The purpose of a continuous risk management process is to be well pre- pared to face the challenges of the evolving present. This is extremely reliant on the readiness of the database system; the adequacy of the information technology system, software, and hardware; the discipline in recording every risk-carrying event; the adequacy of reporting standards; and the construc- tion of analysis procedure, as well as continuous and periodical evaluation. The database system, the adequacy of the information technology system, and the discipline in recording every risk-carrying event are all-important aspects that must be the focus of the Islamic bank’s attention. Without the support of all those aspects, the identification and measurement of risk will experience many obstacles. If errors do happen, but are not registered in the Islamic bank’s database system, then the resulting mea- surement is invalid. Seen from the procurement costs, building a database and information system that are related to risk management is expensive. But the benefits received from the availability of such a risk database and information system, built according to the bank’s need and specification, are much more significant compared to the cost outlay. Organization-Based Risk Mapping Modern risk management practice divides risk into several types. The division is very useful for Islamic banks to differentiate one type of risk from another, enabling them to more accurately identify, measure, and mitigate those risks. Other than dividing risks according to their types, Islamic banks also need to map those various risks to their sources and to the roles of various units in risk management. By mapping the risks, the Islamic bank can more easily identify, measure, and control various

The Islamic Bank and Risk Management 25 Risks Credit Market Liquidity Operational Equity Rate of Investment Return Risk Management General Guidelines and Goals Management Portfolio Risk – Return Profile Portfolio Management Control and Monitoring Risk Department ALM Risk Origination (By Contract) Murabahah Salam Istishna’ Mudharabah Musyarakah Ijarah FIGURE 2.3 Risk Mapping Based on Business Line and Unit Function available risks. Figure 2.3 shows a simple risk-mapping method (only covering several types of risks) based on their sources and the responsibility of each unit in risk management. The source of risk can be mapped based on the line of business owned by the Islamic bank—that is, commercial bank, investment bank, and banking activity in the financial market. All transaction activity entered by a com- mercial bank generates credit risk, liquidity risk, and rate-of-return risk. Credit risk came from transactions channeling loans and financing done by the Islamic bank, and liquidity risk came from the Islamic bank’s activity in assisting in the liquidation process of a customer’s savings. All the transac- tions done by an investment bank also generate credit risk, liquidity risk, and