ISLAMIC RISK MANAGEMENT WORKSHOP SUMMARY

Submitted to: Bilal hafeez Submitted by: Ayesha jamil Afridi

The document gives a detailed synopsis of a workshop conducted on on risk management in Islamic finance on February 26, 2009 between Harvard law school and London school of economics. The workshop had certain key powerful group of, industry practitioners economists academicians, and Islamic legal scholars. The workshop aimed to discuss the characteristics of risk management in Islamic finance and get an understanding of how the 2008-09 financial and economic crises might reform future development.

Introduction to the workshop and topic

Discussions of the financial crises were a important part of the workshop and touched upon matters like how the assessment of the financial market was wronged by the corporate members and risk managers as they proclaimed the financial market un risky and assumed house prices will continuing growing forever. Also, The risk managers were working with inaccurate risk management models that kept on misleading them until it was too late and also working with complex financial instruments that were hard to understand and manage. and how the Islamic finance industry forms an integral part of the whole global financial system and so is also effected by the rising challenges faced by the global financial industry and how the future risk management practices shall effect it The document is divided according to the following topics and sub topics

LESSONS FROM THE FINANCIAL CRISIS

Conventional Thoughts on the Financial Crisis The absence of universal regulators was the main cause of the near breakdown of the global financial structure. Once those who previously thought that minimum regulation would generate more business and stem fuel in to their financial system, are one the ones that demand a more strict control after viewing the disastrous effects of the financial crisis. also these controls are demanded on amore national level leaving the International giants to their bidding. Across the border institutions were more affected because of the fact that when calamity hits central banks focus more on saving their own institutions. Lack of general ethics, dishonesty and partial truths were the products of the financial crisis leading to a widespread loath and wary behaviour from the masses everywhere The two models of liquid and illiquid securities has been reserved entirely by the crisis what was illiquid now become liquid and what was liquid now become illiquid creating a wide gap between liabilities and liquidity. Impartial understanding and not managing risk as it was on all levels (organizational, instrumental,instituational) presented itself as another major cause which contributed to the mayhem. Risk was transferred not on ability but rather on will. There was too much reliance on financial models and those models which were predicted to help steady the markets actually crashed them.

CDS and other derivatives instruments were complex and their documentation could not be easily interpreted and were mislead to believe they could offer abnormal returns for small risk A better and powerful control mechanism is required to prevent institutions from getting too big to fail and conflict of interest is to be managed with an iron hand .investor greed is another problem that needs urgent attention simply put a financial convention which has not received regulatory support is one way of saying that it should be avoided. Islamic Finance Perspectives - Systemic Factors Even the Islamic finance sector was troubled by the impact of the crisis and everyone agreed that this was the high time to bring up solutions for the current problem at hand but a important question still remained unanswered as to whether the Islamic finance model follow the conventional model. Some said that governmental bail was an ineffective tactic and it hardly solves any long term problems instead the if some of the money is lend out to the poor this would initiate a system of deposits that would simulate the economy and help everyone out in the long run Islamic Finance Perspectives - Suggested Solutions The workshop presented some solutions for the problems at hand.following of the solutions are the prevention of the sale of goods that one does not own ( short sales); risk sharing between all parties securing all financial transactions to the real economy and productivity; focusing on arrangements that create real value, productivity and goods & services; Avoidance of excessive transactions those are speculative in nature All parties in a transaction should jointly share risks and profits, and not just take the profits while transferring the risks to others. Theoretically, this action should help avert the growing gap between the very rich and the very poor. Other Islamic solutions include focusing on the virtue of saving; living according to ones means; sacrificing; and indulging in both long term as well as short term planning A very important key is to recover trust and trust generating devices.

Monetary and Economic Considerations Some Islamic consultants felt that a new system should begin which should be customized according to Islamic ideals while others suggested to just make better the existing system .many argued that the current problem with the conventional model is the crack between real economy and productivity and the financial system .use of interest gives rise to artificial levels of demand and supply and makes pricing off the mark and another vital difference between financial and conventional is the risk. In conventional system risk can be separated from the asset and sold off while in Islamic model that is not the case if risk is separated it

forms a type of usury which is haram in Islam. The simple solution would be to incorporate economic transactions with the monetary ones Morality & Ethics Morally the conventional finance sector was in murky waters people were living off mortgages they couldnt afford to pay off investors and sellers were both getting greedy and profiting off other peoples money .all this is not supported in Islam and a vital believe in the creator and being held accountable is a natural facilitator of the Islamic principles in the Islamic environment but the conventional system lacks these ideals and facilitators. Westerners are influenced by law and if got caught world on the other hand the Islamic world has sharia rules which serves as a legislator of morality Introspective Lessons for Islamic Finance Even if Islamic finance sector remained distant from all the chaos everyone agrees that conventional finance cannot be kept at bay from the Islamic finance. If Islamic finance is to work it has to work in some form with its conventional counterpart. In some areas Islamic finance needs help from the conventional finance framework some of these areas are Flexibility in case of crisis Interest rates rise and fall increasing decreasing lending margins

Some said that present financial crisis presented the fact that Islamic finance framework is sufficient to overcome most of the errors of the conventional system if and only if Islamic finance continues to follow its own principles and not lean over excessively to the conventional style of doing business. Many said that current Islamic risk management tools already mirrors the conventional style a lot and if same fate is to be avoided as of conventional finance, a step back is to be taken towards the original Islamic principles Ideals versus Reality Two models exist for the Islamic finance sector one that is ideal and the other realistic. The realistic model is visible in the form of the conventional framework now what constitutes as the ideal is the real question but the workshop did not present any idealistic models instead the idea that a debt free economy linked to real economy should prevail. Different schools of thoughts prevailed about this topic some said: should start moving toward ideal framework immediately achieve both models but gradually move towards the idealistic no change is required in the current system obstacles to the ideal framework should be acknowledged first now that conventional system is down Islamic finance should strive to achieve maximum growth move towards mudaraba and musharaka type products

in process of reaching to the top Islamic sector should protect its investments and a definite change plan should be put into place first with realistic ideals Islamic definite policies should be put in place and not the ones that are some off shoot of the conventional style if this system is to work everything is to be done in Islamic style and solutions proposed should be a product of own separate mindset

ISLAMIC RISK MANAGEMENT

Defining & Categorising Risk There are mentioned 3 types of risks in the Islamic practice 1. al-kharj bi-dhaman this is essential risk that the seller doing a business transaction has to bear unless title of ownership is transferred to the buyer. 2.Gharar Katheer, which is excessive and uncertain risk such as that used in speculation and gambling .in Islam this type of risk is haram and Muslims are strictly prohibited from taking on such risks . This type of risk is also called as gharar jaseem and it can be further categorized into the following sub types of prohibited risks : a.. risk associated with selling an item that is non existent b. risk associated with an item that is not yet repossessed c. risk associated with Quantity or quality being unknown in a transaction e. risk associated with not knowing payment time 3. This third type of risks are described as a combination or in between the two extreme risks they include market risk and operational risk .these risks can be avoided and hedged against Defining Islamic Risk Management Minimizing your risk exposure is what risk management is all about whether you sweep the risk under the rug ,throw in someone else house ,take a small portion of it or not inviting it over at all. All the above situations can be termed as hedging. Speculation is simply inviting risk over without knowing what it will bring with it. Conventional system welcomes it Islamic system prohibits it. One of the reasons for prohibition of risk in Islam is that it does not involve any underlying asset and is not productive for the society as a whole. Islam preaches that risk and reward be shared in equal portions a person involved in a transaction should balance his risk and profit. If this ideology is followed in its core it would help create more tangible, principled, and financially better products tied to real assets and productivity. . Islamic financial sector has to manage a number of risks, such as credit risk liquidity risk market risk, foreign exchange risk

rate of return/profit risk, , Islamic finance faces some additional risks such as ownership risk in murabaha and ijara contracts, which do not occur in conventional banking.

The Case for Islamic Risk Management Issues Concerned that Islamic finance industry is mimicking conventional finance industry But some participants were encouraging derivatives because it helped manage mismatch between liabilities and assets on a banks balance And most customers a product that is both sharia compliant and also priced along the lines of conventional products Differentiation factor between Islamic and conventional is the risk sharing mechanism is the Islamic industry

So in view of all the above issues, it can be generally concluded that hedging is permissible in sharia if the following three conditions are fulfilled: 1. The risks being managed or mitigated should themselves be sharia compliant; 2. Risk management should be by way of sharia compliant means, modes and contracts (as opposed to the use of conventional risk management products); and 3. The objective should be the management, mitigation or lowering of risk only, but not to fully eliminate or to earn profits from such risk by use of conventional styled investment products Makharij and Hiyal Ideas that were put forward makharij :use of legal exceptions, hiyal legal statements. Mafsafa reducing corruptive elements Maslih realizing elements for common good Shubuhaat including doubtful matters Haraam explicit prohibitions Tadrij gradually mukhatara, serve to restore or to maintain a constant, natural equilibrium between sustenance, rizq, and risk itself Risk Shifting versus Risk Sharing Risk shifting is a pure conventional term and all the modern devious derivatives instruments stem from it .risk shifting is helpful in managing interest and thats why the conventional system relies so heavily on it

The Islamic finance model basis is risk sharing in essence that no one party i.e. seller or buyer is burdened with all the risk instead the risk is shared in the way that first the institution bears the risk and then when the underlying asset is delivered the risk is shifted to the buyer Hedging & Speculation Hedging The legal distinction between hedging shariah compliant risks and non shairah compliant risk was made if Islamic finance practitioners stick to the mitigation of shariah compliant risks a culture of entering into speculative agreements by banks would itself be minimized Speculation Many believed that risk management products should be limited to just hedging and not to speculation but that a absurd thought because even for hedging u need someone to speculate first There are 3 types of participants in a conventional system hedgers speculators arbitrageurs

For a normal conventional system to work all three are required but to convert these 3 into a Islamic model would require that every activity they perform should be linked to some real asset

Equity Risks

According to one scholar, sharia has unlimited non-debt based products and not just mudarabah and musharaka. However, while practitioners use equity based tools like musharaka and mudaraba, they do not actually use them for equity purposes. Instead, these tools are used in the majority of cases for debt generating purposes, including for sukuk. Thus, these equity based products were in effect debt based products. This therefore impacts on the risks and the relevant risk management tools required of them. 19

By treating them as debt products, bankers are able to price these equity products close to conventional debt rates as opposed to normal higher charge associated with equity risk levels. Moreover, banks by their very nature as debt institutions are in many ways restricted from pricing them as equity products, which in itself, as one participant pointed out, is a major concern for all the modern conventional economists including Keynes and Freedman. Banks cannot focus on doing equity financing because they cannot take on any additional risks onto their books. Again, this is a by-product due the make-up of fractional reserve banking. Since many Islamic equity based products are treated as debt products, there was a need to discuss why the industry has yet to come up with the right equity risk management assessments to bring these products in line. It was argued that equity risk should be added to the risk management policies of all Islamic financial institutions. Equity risk management goes to the very heart of sharia compliant products in Islamic finance. Participants were unaware of any banks that do this.

Pricing of risks Islamic banks are at a disadvantage when it comes to pricing its products. the conventional banks enjoy the lender of last resort facilities which creates a monopolistic power over money. For Islamic banks other benchmarks other than interest can be created but they would still be more expensive than interest and even if such a benchmark is created its effect would not be long lasting as masses move toward more economic rates. furthermore equity based products are always priced higher than debt and customers in general are not inclined towards expensive products Principal Agent Issues Conflicts of interest are present are present everywhere in both models It can be avoided if practices of transparency and proper disclosure of risk is followed Parties should be made completely aware if potential of a conflict of interest can arise But in all agreed that principle and agent cannot be the same

Regulation Regulatory bodies are in dire need to help the economy achieve its economic ideals Regulation can also help manage and reduce current risk management guidelines and tools

Contractual Conditions If conditions are imposed on the actions of investors speculators and hedgers maybe excessive volatility of the market can be avoided But these conditions might not make any difference too because these conditions could not be enforced on 3rd party transactions and to subsequent trading parties

Waad, Commodity Murabaha and Tawarruq

One sharia scholar recommended that the industry use waad for hedging purposes, but not for speculative purposes. But again, with hedging, there is usually a speculator on the other side as well. While another participant had specific concerns with the current usage of waad, arguing that it can actually amount to an impermissible forward contract. One sharia scholar recommended that the industry should try to avoid continued use of commodity murabaha as much as possible. The reason being is due to how it was devised. A commodity murabaha was originally designed on the basis of a legal exception and to be used only in dire need and necessity. Its continued utilisation also has many other unintended and difficult sharia and legal consequences to deal with. For instance, a parallel commodity murabaha can potentially face sharia challenge if for instance there is a default in one part of the structure, this can automatically default the rest of the structure, which is impermissible in sharia. Furthermore, there was a call to further investigate the ramifications of the use of two-tier mudarbas. It was felt that there was still a clear disconnect between the structure and its use. At the same time, it was suggested (by practitioners) that the industry should not overburden the sharia scholars with queries as to why they permitted commodity murabahas. Yet at the same time, the industry should be asking itself whether there is a real need to develop better alternatives or not. It was also revealed that practitioners themselves face a lot of criticism as to why they need to use a tawarruq transaction in order to provide any rate hedging solution. The difficulty of finding alternatives lies with the dilemma that from a sharia perspective, banks can only pass the intended benefit and proceed through an asset sale mechanism. Otherwise, without this sale transaction, financial institutions are either giving the money away as a loan, which is strictly not permissible in sharia, or there is no real economic transaction occurring between the parties. Therefore, it has been argued that the current best and easiest solution and to meet a real genuine need for such products, hedging is undertaken through use of a tawarruq transaction. Nevertheless, bankers were amenable to discovering better mechanisms to achieve the same purpose, but without the negative complications associated with a tawarruq transaction. Takaful as Hedging Tools

a participant suggested The concept of guaranteed insurance although they are used for hedging purposes they are not without some drawbacks. . Concluding Thoughts The workshop concluded with the final ideas There was need to seek alternative solutions to the current Islamic risk management tools All the solutions that are to be sought should be more Islam specific and not something that mirrors the conventional financial system A new system should be devised according to the Islamic finance system and an incorporation of ethics Regulation and monitoring is difficult in their case Nobody on international level underwrites this risk Most of the companies which were working with this model said they did not understand it Its more expensive than the conventional model.

A more strict regulatory body is to be adopted