RISK MANAGEMENT AND
RISK MANAGEMENT AND
CORPORATE GOVERNANCE IN
CORPORATE GOVERNANCE IN
ISLAMIC FINANCIAL
ISLAMIC FINANCIAL
INSTITUTIONS
INSTITUTIONS
ZULKIFLI HASAN ZULKIFLI HASAN
HAWKAMAH, THE INSTITUTE OF CORPORATE GOVERNANCE HAWKAMAH, THE INSTITUTE OF CORPORATE GOVERNANCE
26
CONTENTS
CONTENTS
Introduction
Introduction
Case Study: Closure of Ihlas Finance, due to Poor
Case Study: Closure of Ihlas Finance, due to Poor
Corporate governance (CG)
Corporate governance (CG)
What is CG?
What is CG?
Why it is important to Islamic risk management
Why it is important to Islamic risk management
system?
system?
Elements of Good CG in IFIs
Elements of Good CG in IFIs
Risk Management in IFIs
Risk Management in IFIs
Roles of Board of Directors (BOD) and Senior
Roles of Board of Directors (BOD) and Senior
Management
Management
Roles of Shari’ah Board
Roles of Shari’ah Board
Financial Distress and Failure of Ihlas Finans
Financial Distress and Failure of Ihlas Finans
Financial Crisis in Turkey 2000-2001.
Financial Crisis in Turkey 2000-2001.
One Islamic institution Ihlas Finans
One Islamic institution Ihlas Finans
(the frst domestic IFI in Turkey) was
(the frst domestic IFI in Turkey) was
closed during the crisis while the other
closed during the crisis while the other
fve Islamic bsanks were survived.
fve Islamic bsanks were survived.
Ihlas Finans is a special fnance house
Ihlas Finans is a special fnance house
estabslished in 1995 and was a
estabslished in 1995 and was a
subssidiary of Ihlas Holdings.
subssidiary of Ihlas Holdings.
The BRSA cancelled the license of
The BRSA cancelled the license of
Ihlas Finans on 10
Factors
Factors
Accumulation of bsad debstAccumulation of bsad debst- Politically motivated - Politically motivated
lending and lending to connected bsusiness. Finance lending and lending to connected bsusiness. Finance the bsusinesses of its parent company, Ihlas Holdings. the bsusinesses of its parent company, Ihlas Holdings.
Lax Regulation- Lax Regulation- Law on full guarantee of the bsank Law on full guarantee of the bsank
deposits ofered bsy the State made bsanking a deposits ofered bsy the State made bsanking a
lucrative bsusiness for the corrupt entrepreneurs with lucrative bsusiness for the corrupt entrepreneurs with political connections who set up bsanks that siphoned political connections who set up bsanks that siphoned of money.
of money.
Major proportion of the investment was an illiquid Major proportion of the investment was an illiquid
assets
assets and projects as compared to other domestic and projects as compared to other domestic and foreign commercial bsanks who could hold very and foreign commercial bsanks who could hold very liquid government securities.
liquid government securities.
Failures in CG and lack of internal checks and Failures in CG and lack of internal checks and
bsalances
bsalances:- Control failure, Management failure and :- Control failure, Management failure and regulatory failure.
What is CG?
What is CG?
CG is the system by which business corporations are
CG is the system by which business corporations are
directed and controlled .
directed and controlled .
CG specifies the distribution of rights and
CG specifies the distribution of rights and
responsibilities among different participants in the
responsibilities among different participants in the
company such as BOD, Shari’ah board, managers,
company such as BOD, Shari’ah board, managers,
shareholders, and other stakeholders.
shareholders, and other stakeholders.
A concept of CG in IFIs presents distinct
A concept of CG in IFIs presents distinct
characteristics and features in comparison with the
characteristics and features in comparison with the
conventional system as it goes beyond the financial
conventional system as it goes beyond the financial
return whereby it covers the element of ethic,
return whereby it covers the element of ethic,
Shari’ah and beliefs (aqidah).
Shari’ah and beliefs (aqidah).
Shari’ah board plays significant role to supervise ,
Shari’ah board plays significant role to supervise ,
oversea and advise the shari’ah aspects of the
oversea and advise the shari’ah aspects of the
corporation.
Why CG is important for risk
Why CG is important for risk
management in IFIs?
management in IFIs?
Hypothesis 1: Weak CG may lead to
Hypothesis 1: Weak CG may lead to
inefective risk management system.
inefective risk management system.
Hypothesis 2: Strong commitment to
Hypothesis 2: Strong commitment to
good CG will improve and strengthen
good CG will improve and strengthen
risk management system in IFIs
risk management system in IFIs
Case Study: Ihlas Finans was closed
Case Study: Ihlas Finans was closed
in 2001 due to poor CG while the
in 2001 due to poor CG while the
other fve Islamic banks in Turkey
other fve Islamic banks in Turkey
were survived because of better CG.
Existing Studies
Existing Studies
Well governed UK companies posted 18% higher
Well governed UK companies posted 18% higher
returns than those with poor governance after
returns than those with poor governance after
adjusting for risk (ABI Research Paper 7: 2008);
adjusting for risk (ABI Research Paper 7: 2008);
Well governed frms in Korea have bseen found to
Well governed frms in Korea have bseen found to
trade at a premium of 160% to poorly governed
trade at a premium of 160% to poorly governed
frms (Black, B lt al: 20040);
frms (Black, B lt al: 20040);
A study of S&P 500 frms showed that companies
A study of S&P 500 frms showed that companies
with strong or improving CG practices
with strong or improving CG practices
outperformed those with poor or deteriorating
outperformed those with poor or deteriorating
governance practices bsy absout 19% over a
governance practices bsy absout 19% over a
2-year period (Grandmont, R lt al: 20040).
year period (Grandmont, R lt al: 20040).
A worst-to-bsest improvement in CG predicted an
A worst-to-bsest improvement in CG predicted an
astronomical 700-fold increase in frm value
astronomical 700-fold increase in frm value
among Russian frms (Black, B: 2001).
The Six Elements of Good CG in
The Six Elements of Good CG in
Risk Management in IFIs
Risk Management in IFIs
Certain types of risks are of equal concern
Certain types of risks are of equal concern
to all fnancial institutions, including IFIs.
to all fnancial institutions, including IFIs.
IFIs face additional risks that emanate
IFIs face additional risks that emanate
from the unique characteristics of Islamic
from the unique characteristics of Islamic
fnance transactions, along with risks
fnance transactions, along with risks
associated with the real or perceived
associated with the real or perceived
non-compliance of Shariah principles.
compliance of Shariah principles.
The survival and success of IFIs depends
The survival and success of IFIs depends
on the eficiency in which they can
on the eficiency in which they can
manage its risks and how they will
manage its risks and how they will
manage diferent risks arising from their
manage diferent risks arising from their
How good CG may improve Risk
How good CG may improve Risk
Management System?
Management System?
IFIs shall have in place a
IFIs shall have in place a
comprehensive risk management and
comprehensive risk management and
reporting process, including
reporting process, including
appropriate board and senior
appropriate board and senior
management oversight
management oversight
, to identify,
, to identify,
measure, monitor, report and control
measure, monitor, report and control
relevant categories of risks and, where
relevant categories of risks and, where
appropriate, to hold adequate capital
appropriate, to hold adequate capital
against these risks.
against these risks.
The process shall take into account
The process shall take into account
appropriate steps
appropriate steps
to comply with
to comply with
Sharī`ah
Sharī`ah
rules
rules
and principles and to
and principles and to
ensure the adequacy of relevant risk
ensure the adequacy of relevant risk
reporting to the supervisory authority.
Roles of Board and Senior
Roles of Board and Senior
Management
Management
Approve the risk
Approve the risk
management objectives,
management objectives,
strategies, policies and procedures
strategies, policies and procedures
;
;
Ensure the existence of
Ensure the existence of
an efective risk
an efective risk
management structure
management structure
for conducting IFIs’
for conducting IFIs’
activities, including adequate systems for
activities, including adequate systems for
measuring, monitoring, reporting and
measuring, monitoring, reporting and
controlling risk exposures;
controlling risk exposures;
IFIs shall have in place
IFIs shall have in place
an appropriate
an appropriate
body, in accordance with sound principles
body, in accordance with sound principles
of CG
of CG
, to oversee that all products and
, to oversee that all products and
activities comply with
activities comply with
Sharī`ah
Sharī`ah
rules and
rules and
principles as approved in each jurisdiction
Cont…
Cont…
Approve
Approve
limits on aggregate fnancing and
limits on aggregate fnancing and
investment exposures
investment exposures
to avoid concentration
to avoid concentration
of risk and, ensure that IFIs hold adequate
of risk and, ensure that IFIs hold adequate
capital against these exposures.
capital against these exposures.
Review the efectiveness of the risk
Review the efectiveness of the risk
management
management
activities periodically and make
activities periodically and make
appropriate changes as and when necessary.
appropriate changes as and when necessary.
Execute the strategic direction
Execute the strategic direction
set by the
set by the
BOD on an ongoing basis and set clear lines
BOD on an ongoing basis and set clear lines
of authority and responsibility;
of authority and responsibility;
Senior management shall ensure that the
Senior management shall ensure that the
risk management function is
risk management function is
independent
independent
from the risk-taking activities
from the risk-taking activities
and is
and is
reporting directly to the BOD or senior
reporting directly to the BOD or senior
management outside the risk-taking unit.
Types of Risk Roles of BOD and Senior Management
Credit Risk •Strategy for fnancing and recognize the potential
credit exposures.
•Carry out due diligence review
•Appropriate methodologies for measuring and
reporting credit risk exposure
•Shariah-compliant credit risk mitigating
techniques Equity
Investment Risk
•Strategy for risk characteristics of equity investments
•Appropriate valuation methodologies
•Establish exit strategies in respect of equity investment activities
Market Risk •Appropriate framework for market risk
management in respect of all assets held Liquidity
Risk
•Appropriate liquidity management framework
•Able to assume that liquidity risk commensurate with their ability to have suficient recourse to Shariah-compliant funds to mitigate such risks Rate of
Return Risk
•Comprehensive risk management and reporting
process to assess the potential impacts of market factors afecting rates of returns on assets in
comparison with the expected returns for IAH Operational
Risk
•Adequate system and controls to ensure Shariah compliance
Roles of Shari’ah Board
Roles of Shari’ah Board
IFIs shall have adequate system of controls
IFIs shall have adequate system of controls
including Shari’ah governance (SG) system.
including Shari’ah governance (SG) system.
SG is a set of institutional and
SG is a set of institutional and
organizational arrangements through which
organizational arrangements through which
IFIs ensure that there is independent
IFIs ensure that there is independent
oversight of Shari’ah compliance.
oversight of Shari’ah compliance.
IFIs shall have in place a Shari’ah bsoard
IFIs shall have in place a Shari’ah bsoard
(SB) to review and ensure that all fnancing
(SB) to review and ensure that all fnancing
proposals are Shari’ah compliant at all
proposals are Shari’ah compliant at all
times.
times.
Internal/lxternal Shari’ah review unit to
Internal/lxternal Shari’ah review unit to
assist the SB for Shari’ah-compliance
assist the SB for Shari’ah-compliance
purpose.
How Shari’ah governance
How Shari’ah governance
complements the existing
complements the existing
Shari’ah Non-Compliance Risk
Shari’ah Non-Compliance Risk
IFIs are exposed to risk relating to IFIs are exposed to risk relating to Shari’ah non-Shari’ah
non-compliance risks
compliance risks and also and also to reputational riskto reputational risk. .
These risk exposes IFIs to fund providers’ These risk exposes IFIs to fund providers’
withdrawals, loss of income or voiding contracts withdrawals, loss of income or voiding contracts
leading to a diminished reputation or the leading to a diminished reputation or the
limitation of bsusiness opportunities. limitation of bsusiness opportunities.
IFIs shall at all times IFIs shall at all times comply with the Shari’ah comply with the Shari’ah
rules and principles as determined bsy the SB rules and principles as determined bsy the SB
with respect to products, activities and contract with respect to products, activities and contract
documentation. documentation.
IFIs shall IFIs shall undertake a Shari’ah compliance undertake a Shari’ah compliance
review review. .
IFIs shall IFIs shall keep track of income not recognized keep track of income not recognized
Some Impact of Shari’ah
Some Impact of Shari’ah
Non-Compliance Risk
Compliance Risk
Slowdown of globsal Sukuk issuance.
Slowdown of globsal Sukuk issuance.
By the end of 2008, globsal Sukuk issuance had
By the end of 2008, globsal Sukuk issuance had
declined bsy more than 50% compared to 2007.
declined bsy more than 50% compared to 2007.
Chairman of the AAOIFI Shari’ah bsoard-
Chairman of the AAOIFI Shari’ah bsoard-
criticized a common form of sukuk that
criticized a common form of sukuk that
apparently violates the Sharia-compliant
apparently violates the Sharia-compliant
principles surrounding risk and proft-sharing.
principles surrounding risk and proft-sharing.
He estimated that up to 85% of Gulf Sukuk
He estimated that up to 85% of Gulf Sukuk
structures were not Shari’ah-compliant.
structures were not Shari’ah-compliant.
AAOIFI made a recommendation to Islamic
AAOIFI made a recommendation to Islamic
fnance market participants to refrain from
fnance market participants to refrain from
issuing Sukuk structures that have a purchase
issuing Sukuk structures that have a purchase
undertaking or guarantee from the Sukuk issuer
undertaking or guarantee from the Sukuk issuer
to repurchase at a future date at a specifc price.
Concluding Remarks
Concluding Remarks
Good CG is crucial in providing efective risk Good CG is crucial in providing efective risk
management system.
management system.
Certain types of risks are of equal concern to all Certain types of risks are of equal concern to all
institutions ofering fnancial services, but there
institutions ofering fnancial services, but there
are certain specifc risks which are exclusive to
are certain specifc risks which are exclusive to
IFIs.
IFIs.
Board of Directors and Senior management have Board of Directors and Senior management have
specifc roles in relation to
specifc roles in relation to risk management risk management
objectives, strategies, policies and procedures in
objectives, strategies, policies and procedures in
order to mitigate all types of risks.
order to mitigate all types of risks.
Shari’ah board is more concerned on the aspect Shari’ah board is more concerned on the aspect
of Shari’ah non-compliance and reputational
of Shari’ah non-compliance and reputational
risks.
risks.
IFIs need for a set of best practices of corporate IFIs need for a set of best practices of corporate
governance and efective risk Management that
governance and efective risk Management that
give practical efect to managing the underlying
give practical efect to managing the underlying
risks.
References
References
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from Closure of Ihlas Finans in Turkey
from Closure of Ihlas Finans in Turkey, , Islamic Economic Studies, Vol. Islamic Economic Studies, Vol. 14, No. 1 & 2, Aug. 2006 & Jan. 2007, pp: 1-52.
14, No. 1 & 2, Aug. 2006 & Jan. 2007, pp: 1-52.
ABI Research Paper 7. (February 2008). ABI Research Paper 7. (February 2008). Governance and Performance in Governance and Performance in
Corporate Britain
Corporate Britain. London: The Association of British Insurers.. London: The Association of British Insurers.
Black, B. S. Jang, H and Kim, W (2004). Black, B. S. Jang, H and Kim, W (2004). Predicting Firms CG Choices: Predicting Firms CG Choices:
Evidence From Korea.
Evidence From Korea. University of Texas Law School Working Paper No. University of Texas Law School Working Paper No. 39, August.
39, August.
Black, B. (2001). Black, B. (2001). The CG Behavior and Market Value of Russian FirmsThe CG Behavior and Market Value of Russian Firms. .
Emerging Market Review, Vol. 2, March. Emerging Market Review, Vol. 2, March.
Grandmont, R, Grant, G. and Silva, F. (2004). Grandmont, R, Grant, G. and Silva, F. (2004). Beyond the Numbers- CG: Beyond the Numbers- CG:
Implications for Investors
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Hijazi, Faisal. (2009). Global Sukuk Issuance: 2008 Slowdown Mainly Due Hijazi, Faisal. (2009). Global Sukuk Issuance: 2008 Slowdown Mainly Due
to Credit Crisis and Some Impact on Shari’ah compliance issues. to Credit Crisis and Some Impact on Shari’ah compliance issues. International Structured Finance Special Report.
International Structured Finance Special Report.
IFC and Hawkamah. (2008). IFC and Hawkamah. (2008). A Corporate Governance Survey of Listed A Corporate Governance Survey of Listed
Companies and Banks Across the Middle East & North Africa Companies and Banks Across the Middle East & North Africa. . Washington: IFC.
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IFSB Exposure Draft Guiding Principles on Shari’ah Governance System.IFSB Exposure Draft Guiding Principles on Shari’ah Governance System. IFSB Guiding Principles of Risk Management For Institutions (Other IFSB Guiding Principles of Risk Management For Institutions (Other