Accounting for Risk - Business Islamica

79% of IFIs established a risk department in last 5 years.

The global financial crisis continues to hit hard. The financial services ? including Islamic Finance ? are facing a catalogue of regulatory and practice-related reforms.

This new wave of regulatory reforms, aimed at upholding best practices, has renewed emphasis on prudential oversight and good governance. These changes resulted in greater pressures on financial institutions offering Islamic financial services (IIFS) to galvanize their risk exposures and governance capabilities. Moreover, the complexity of Shari?ah-compliant debt and equity instruments has evolved, and types of risks, issues and investors, as well as market conditions, have emerged, all of which have made it imperative for IIFS to develop and adopt integrated risk management strategies, in order to protect their businesses and stakeholders.

A report recently published by the Deloitte Middle East Islamic Finance Knowledge Center (IFKC), entitled ?Empowering Risk Intelligence in Islamic Finance: Managing Risk in Uncertain times?, addresses and investigates the important issues in practice and regulation in Islamic Finance in the current market challenges.

The Deloitte report is based on a survey and group of case studies developed during the second half of 2011, on 20 leading Islamic Financial institutions from the Middle East and South East Asia, with aggregate assets of more than $50 billion. It also includes several interviews conducted with industry leaders and risk management executives.

The report focuses on the governance and structural aspects of an effective risk management framework in Islamic Finance and identifies three closely-linked issues: risk governance, regulatory pressures and accountability. It also outlines the challenges faced by institutions offering Islamic financial services (IIFS) to develop effective risk intelligence functions.

?Greater pressure has been placed on financial institutions offering Islamic Financial services to galvanize risk exposure and governance capabilities,? commented Dr. Hatim El Tahir, director of the Deloitte Middle East Islamic Finance Knowledge Center (IFKC).

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The Deloitte report further finds that although the practice of Enterprise Risk Management (ERM) is relatively new in the Islamic Finance sector 79% of the institutions that took part in the survey established a risk department in the last five years. However, only 5% of the IIFS? risk departments were set up more than 10 years ago.

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?The complexity of Shari?ah compliant debt and equity instruments has evolved, and the types of risks, issues and investors, as well as market conditions have emerged. These factors combined have made it imperative for IIFS to develop and adopt integrated risk management strategies, in order to protect their businesses and stakeholders,? El Tahir added.

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The Deloitte survey indicates that 83% of the Islamic Financial institutions surveyed have both a formal risk management function that manages the risk activities, and a risk committee that oversees all risks. Moreover, 87% of the Islamic Financial institutions surveyed have ?management members? on their risk committees.

In terms of accountability for the Enterprise Risk Management program, 32% of the surveyed institutions have indicated that the CEO is accountable for risk; while 27% hold the Chief Risk Officer and 13% hold the Head of Risk Management accountable. Thus, the report suggests that IIFS management and decision-makers should support the risk governance process with subject matter experts for in-depth analysis and adequate selection of risk solutions and strategies.

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The Deloitte Risk Intelligence in Islamic Finance survey findings indicate? the following key challenges that warrant the attention of Islamic Finance sector leaders and stakeholders:

• 63% of respondents believe that strong commitment is required from all of Financial Institutions Boards?, Shari?ah Supervisory Boards and Management to improve ERM in Islamic Finance.
• 65% of the institutions offering Islamic Financial Services (IIFS) that participated in the survey are considering the development of an ERM program.
• Only 59% of the IIFS that participated have implemented the Islamic Finance Services Board?s (IFSB) Risk Management Standard.
• 63% reported that they have not received any external rating, and less than a quarter of the respondents had considered or received external rating from an Islamic rating agency. This constitutes a real challenge posed to industry participants and standard-setters such as the IFSB, Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), International Islamic Financial Market (IIFM) and the Islamic International Rating Agency (IIRA), to enforce best practices.
• Creating a risk-aware culture is considered the most (68%) important benefit of ERM.
• The IIFS lack skilled risk experts, and institutions are required to invest in building capabilities in key risk management pillars ? People, Process, Technology and Governance.
• 56% of the group studied has risk management software, and 44% of them lag behind in automation of risk information management. In contrast, 71% of the group surveyed in the Deloitte report has implemented the IFSB?s Guiding Principles on Shari?ah Governance. Key causes of Shari?ah compliance risks include non-standardized practices, diverse Shari?ah interpretations, and the lack of enforcement of Shari?ah laws in many jurisdiction

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Risk governance in Islamic Finance

Risk drivers in Islamic Finance stem from common conventional known types of risks, as well as the unique Shari?ah compliance risk that shapes the operations of the IIFS business. The latter constitutes a fundamental prerequisite factor for developing any risk management strategy for the IIFS whether in sourcing of funds or use of funds. It is, however, the role of Boards and executives that ensures compliance to Shari?ah principles in all levels of IIFS operations and management of their assets. In discussing risk governance in Islamic Finance, two key factors warrant consideration ? first the embodied element of the fiduciary relationship between the SSB, Board, management and other stakeholders of the institution and secondly the importance of transparency and disclosure in these unique operational and management relations.

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The essence of the fiduciary relationship

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The fiduciary relationship between the shareholders, investors and other stakeholders is paramount in understanding the regulatory needs of risk management and its practice. The common theme in this unique relationship is good governance and an adequate financial and management reporting mechanism. Key to this is the role of Shari?ah Supervisory Boards (SSBs) in vetting business suitability to comply with Shari?ah principles, and its obligation to safeguard the interest of investors, management and clients.

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Graph 5: Extent of risk management integration in decision-making process?

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This important role is galvanized by support from interdependent business units and functions such as legal, human resources, tax/Zakat, information technology, and finance. These interdependent units harness the task of identifying, measuring, managing, and monitoring risks, in four main ways:

? Strategy: developing institution-wide policies and procedures and controls that help build risk governance

? Planning: providing required resources and information management

? Transparency: ensuring homogenous flow of information and standardized practice

? Education and training: identifying training needs and skills development within the institution.

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Prudential oversight, good corporate governance and financial reporting and disclosure are key factors to ensure effective risk management in Islamic Finance. The three-party interdependent approach of disclosure and reporting in Islamic Finance consists of interaction and coordination between three main parties. The coordination between the SSB, internal audit and external audit is a similarly

important process in risk management which ensures consistency, standardization and Shari?ah-compliance at all levels of the institution?s operation. Consequently, Islamic Finance risk executives are required to develop risk management strategies that address the full spectrum of risks, including industry specific ones such as Shari?ah compliance, competition, community development, strategic, reporting, and operational. Four key categories of risk areas are identified:

1. Enhance risk governance strategy aligned with Board?s support and oversight.

2. Enhance operational risk assessment and process standardization.

3. Integrate Shari?ah compliance in all operational risks and process strategies.

4. Standardize and enhance disclosure and reporting procedures.

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Deloitte IFKC?s risk intelligence in Islamic Finance:

This section is based on the findings of a survey conducted in 2011. The questions and interviews with risk executives across the region were structured around Deloitte?s four ERM capabilities:

? Governance

? Process

? People

? Technology

Graph three- Deloitte ERM capability model

Governance: The governance capability focuses on the structure and organization of the risk management function in order to make risk-intelligent decisions and execute those decisions in a timely and effective manner.

Process: The process capability focuses on the process in place to execute risk management.

People: The people capability focuses on having the right number of people with the appropriate training and awareness to execute the risk management process.

Technology: The technology capability focuses on IT systems used to analyze and communicate risk information throughout the organization as well as to enable risk-intelligent decision-making in a timely manner.

Thought leaders? perspective on Risk Management

Deloitte IFKC organized ?intellectual knowledge dialogue? with Islamic Finance thought leaders on those four capabilities. ?Below are a few responses.

Governance

Professor John Board, Dean, Henley Business School, University of Reading, UK: ?Recent events, whether affecting conventional or Islamic Finance, have revealed that there are still deficiencies in the management of risk. The technical issues of the identification, measurement and reporting of risk are the subject of detailed scrutiny by the various Risk Professionals? Institutes and research in firms and universities worldwide. More worrying is the ongoing challenges faced by several institutions to fully adapt to the new governance requirements and technology implications of the crisis.?

Mahomed Akoob, Managing Director, Hannover ReTakaful: ?One of the beauties of Shari?ah is that it allows interpretation as situations demand. It is open for ijtihad. However, a Takaful operator domiciled under one jurisdiction and wanting to grow and write business under another is highly likely to face different interpretations of the governing Shari?ah regime regulations. Perhaps practitioners should plead with regulators to try and consider a form of consensus.?

Daud Vicary, President and CEO, INCEIF, Malaysia: ?In Islamic Finance the development of governance framework is still relatively slow and in need of serious attention. The regulators should obtain inputs from industry, Shari?ah scholars and academicians in developing a robust framework.?

Process

Ijlal Alvi, the CEO of IIFM: ?There are differences between the conventional financial system as compared to the Islamic financial system in terms of core operational and business processes; for example, in conventional derivative products the risk is detached from the balance sheet items and is traded separately while in the case of Islamic hedging, the requirement is directly linked to economic activity or balance sheet items and there is no trading of risk.?

Mahomed Akoob: ?The necessity of disciplined underwriting and ?risk commensurate pricing in the face of severe competition among Takaful operators themselves and with conventional insurers is a tightrope that Takaful and Retakaful operators alike are walking.?

For an effective process in risk management, Shaji Chandrasena, Director, Financial Risk Supervision, Monetary Authority of Singapore, believes that IIFS should ?carry out consistent independent and rigorous valuation practices across the firm?.

People

Khalid Howladar, Senior Credit Officer, Islamic Finance, Moody: ?The industry already has a shortage of human capital and the complexity of Islamic Finance (and associated financial statements) requires more oversight and attention.?

Daud Vicary: ?The industry lacks practitioners who are Shari?ah savvy and Shari?ah experts who are market savvy. This process can only be carried out by educational institutions like INCEIF where specific course modules and programs that combine the two areas are taught.?

Mahomed Akoob: ?Any employer looks for two aspects in recruitment: high caliber and retention thereof. With the relative scarcity of qualified Islamic Finance professionals and the sheer competition over this limited talent pool, operational risk needs careful monitoring.?

Technology

Ijlal Alvi: ?The hedging tools to mitigate certain risk such as currency and rate of return mismatches as well as enabling law reforms are the most crucial and challenging areas in the Islamic financial services industry.?

Daud Vicary: ?Customized risk management technology is necessary to be in place. Genuine efforts are needed to develop such platforms and need to come through a combination of market practitioner, academic and Shari?ah scholar.?

Ahmed Adil, Global Head of Risk Management, Arcapita Bank, Bahrain: ?A Management Information System should be based on ?group exposure? for all allied industries and the correlation impact be computed in risk modeling and risk capital estimation.?

Responding to these new realities may require effective risk governance. IIFS Boards, Shari?ah Supervisory Boards and executives have an important role to play in providing proactive oversight of risk management and risk strategy. The executive risk officers equally play an important role in coordinating risk management implementation and activities between boards and Shari?ah Supervisory Boards and other business supporting units in the institution.

BOX: IFKC

The Islamic Finance Knowledge Center (IFKC) is a Center of Excellence established to provide Islamic Finance thought leadership to industry professionals. Based on the work of its Intelligence and Research function, the Center imparts knowledge, skills, and innovation in thought with a view to promoting and implementing change in Islamic Finance practices around the world. As a result, the IFKC represents a one-stop shop for practitioners who seek to acquire knowledge and competency in different areas of technical expertise and Islamic Finance governance.

The IFKC is active on a number of levels including:

• Compiling a library of reference books, standards and industry report
• Issuing IKFC research and reports to industry stakeholders
• Holding IFKC seminars and workshops to update professionals on industry issues
• Conducting surveys of Islamic Finance leaders
• Sharing webcasts featuring discussions with experts and policy-makers
• Publishing e-magazine to share thought leadership with clients and markets
• Participating in public events to raise awareness and educate

About Deloitte:

With a globally connected network of member firms in more than 150 countries, and nearly 182,000 professionals, Deloitte provides audit, tax, consulting, and financial advisory services to public and private clients spanning multiple industries.

About Deloitte & Touche (M.E.):

Deloitte & Touche (M.E.) is a member firm of Deloitte Touche Tohmatsu Limited (DTTL) and is the first Arab professional services firm established in the Middle East region with uninterrupted presence for over 85 years. Deloitte is among the region?s leading professional services firms, providing audit, tax, consulting, and financial advisory services through 26 offices in 15 countries with over 2,500 partners, directors and staff.

Source: http://businessislamica.com/2012/08/13/accounting-for-risk-2/

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