Summary-SBP Risk Management guidelines for IBIs
Summary of Risk Management Guidelines for Islamic Banking Institutions
Risk Management Guidelines for Islamic Banking Institutions (IBIs) have been issued vide
IBD Circular No. 01 of 2008 by tailoring the IFSB guiding principles on Risk Management.
These guidelines are in addition to the various Risk Management Guidelines issued by SBP
from time to time. These Guidelines provide a set of best practices for establishing and
implementing effective risk management in IBIs. These Guidelines set out fifteen principles
of risk management that give practical effect to managing the risks underlying the business
objectives that IBIs may adopt. One principle is defined for general requirement whereas
other 14 principles provide specific guidance for six risk categories.
General Requirement: According to first principle,
• IBIs shall have in place a comprehensive risk management and reporting process,
including appropriate board and senior management oversight, to identify, measure,
monitor, report and control relevant categories of risks. The process shall take into
account appropriate steps to comply with Shariah rules and principles and to ensure
the adequacy of relevant risk reporting to the supervisory authority.
IBIs shall have a sound process for executing all elements of risk management, including risk
identification, measurement, mitigation, monitoring, reporting and control. This process
requires the implementation of appropriate policies, limits, procedures and effective
management information systems (MIS) for internal risk reporting and decision making that
are commensurate with the scope, complexity and nature of IBIs’ activities.
Credit Risk: The risk assessment and measurement processes undertaken by IBIs shall be
applicable to profit sharing assets which are classified under equity investments. Rigorous
risk evaluation and controls of these investments are necessary in view of their exposure to
capital impairment. According to four principles regarding this risk category which are also
applicable to credit risks associated with securitization and investment activities, IBIs shall:
• have in place a strategy for financing, using various instruments in compliance
with Shariah, whereby they recognize the potential credit exposures that may
arise at different stages of the various financing agreements.
• carry out a due diligence review in respect of counterparties prior to deciding on
the choice of an appropriate Islamic financing instrument.
• have in place appropriate methodologies for measuring and reporting the credit
risk exposures arising under each Islamic financing instrument.
• have in place Shariah-compliant credit risk mitigating techniques appropriate
for each Islamic financing instrument.
IBIs shall define and set the institution’s overall levels of risk appetite, risk diversification
and asset allocation strategies applicable to each Islamic financing instrument, economic
activity, geographical spread, season, currency and tenor. They shall establish policies and
procedures defining eligible counterparties, the nature of approved Shariah Compliant
financings and types of appropriate financing instruments. They must obtain sufficient
information to permit a comprehensive assessment of the risk profile of the counterparty prior
to the financing being granted. Their approval process should engage appropriate experts,
including a Shariah advisor. Depending on the Islamic financing instrument, the IBIs may
employ an appropriate methodology that takes into account price volatilities of underlying
assets. The selected methodology shall be appropriate given the nature, size and complexity
of the IBIs’s credit related activities. They shall ensure that adequate systems and resources
are available to implement this methodology.
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Furthermore, they shall clearly define their credit risk-mitigating techniques including having
in place a methodology, clear documentations & procedures and permissible and enforceable
collateral and guarantees. They should have appropriate credit management systems and
administrative procedures in place to undertake early remedial action in the case of financial
distress of counterparty or, in particular, for managing problem credits, potential and
defaulting counterparties. They shall establish appropriate policies and procedures that
require them to honour their commitment to the parallel contract counterparty as well as with
their own exposure in parallel transaction. They shall also have in place an appropriate policy
for determining and allocating provisions for doubtful debts including counterparty exposures
and estimated impairment in value of leased assets.
Equity Investment Risk: Investments made via Mudarabah and Musharakah instruments may
contribute substantially to IBIs’ earnings, they entail significant market, liquidity, credit and
other risks, potentially giving rise to volatility in earnings and capital. This section sets out
the principles pertaining to the management of risks inherent in the holding of equity
instruments for investment purposes. According to three guiding principles defined for this
risk category, IBIs shall:
• have in place appropriate strategies, risk management and reporting processes in
respect of the risk characteristics of equity investments, including Mudarabah
and Musharakah investments.
• ensure that their valuation methodologies are appropriate and consistent, and
shall assess the potential impacts of their methods on profit calculations and
allocations. The methods shall be mutually agreed between the IBIs and the
Mudarib and/or Musharakah partners.
• define and establish the exit strategies in respect of their equity investment
activities, including extension and redemption conditions for Mudarabah and
Musharakah investments, subject to the approval of the institution’s Shariah
Advisor.
In evaluating the risk of an investment using the profit sharing instruments, the risk profiles
of potential partners are crucial considerations for the undertaking of due diligence. Such due
diligence is essential to the fulfillment of IBIs’ fiduciary responsibilities as an investor of
deposits in such modes. These risk profiles include the past record of management team and
quality of business plan of, and human resources involved in, the proposed investment
activity. IBIs shall ensure that proper infrastructure and capacity are in place to monitor
continuously the performance and operations of the entity in which IBIs invest as partners.
They shall identify and monitor the transformation of risks at various stages of investment
lifecycles. IBIs that employ different financing instruments at different contract stages shall
have appropriate procedures and controls in place, as different stages may give rise to
different risks. They shall also analyze and determine possible factors affecting the expected
volume and timing of cash flows for both returns and capital gains arising from equity
investments.
IBIs shall use Shariah compliant risk-mitigating techniques like Shariah permissible security
from the partner, which can reduce the impact of possible capital impairment of an
investment. Valuation and accounting play an important role in measuring the quality of an
equity investment. An appropriate and agreed method to be applied to determine profit of the
investment can be in the form of a certain percentage of either gross or net profit earned by
the profit sharing business, or any other mutually agreed terms. IBIs shall also recognize that,
as a going concern, an investee may not always have the liquidity necessary to enable making
profit distributions. Hence, they shall agree with the investment partner the methods for
treatment of retained profits by the investee. They should also assess and take measures to
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deal with risks associated with potential manipulation of reported results leading to
overstatements or understatements of partnership earnings.
Market Risk: It is the risk of losses in on- and off-balance sheet positions arising from
movements in market prices i.e. fluctuations in values in tradable, marketable or leasable
assets (including sukuk) and in off-balance sheet individual portfolios. The risks relate to
current and future volatility of market values of specific assets and of foreign exchange rates.
When IBIs are involved in buying assets that are not actively traded with the intention of
selling them, it is important to analyze and assess the factors attributable to changes in
liquidity of the markets in which the assets are traded and which give rise to greater market
risk. Assets traded in illiquid markets may not be realizable at prices quoted in other more
active markets. One principle is described for market risk i.e.,
• IBIs shall have in place an appropriate framework for market risk management
(including reporting) in respect of all assets held, including those that do not have a
ready market and/or are exposed to high price volatility.
Liquidity Risk: It is the potential loss to IBIs arising from their inability either to meet their
obligations or to fund increases in assets as they fall due without incurring unacceptable costs
or losses. There are two major types of fund providers. i.e. Current account holders & PLS
deposit holders. As current account holders do not participate in profits of the IBIs’ business
activities, a sound repayment capacity is required to meet fully cash withdrawal requests as
and when they arise. Whereas, PLS deposit holders are those depositors who participate in
the uncertainties of IBIs’ business; therefore, they share in profits and bear losses arising
from investments made on their behalf, to the extent of their share. Apart from general
withdrawal needs, the withdrawals made by PLS deposit holders may be result of lower than
expected or acceptable rates of return, concerns about the financial condition of the IBIs and
non-compliance by the IBIs with Shariah rules and principles in various contracts and
activities. According to two principles for liquidity risk, IBIs shall:
• have in place a liquidity management framework (including reporting) taking into
account separately and on an overall basis their liquidity exposures in respect of
each category of current accounts and PLS deposits.
• assume liquidity risk commensurate with their ability to have sufficient recourse to
Shariah-compliant funds to mitigate such risk.
IBIs shall establish the maximum amounts of cumulative liquidity mismatches which they
consider acceptable and manageable for different time bands, as a percentage of total assets
available. The effects of liquidity shortages may vary according to the fund providers’
liquidity preferences; hence, separate limits on liquidity mismatches should be set up
accordingly. These limits shall be regularly reviewed, taking into account the IBIs’ liquidity
situation, economic climate and market conditions.
Rate of Return Risk: IBIs are exposed to rate of return risk in the context of their overall
balance sheet exposures. An increase in benchmark rates may result in PLS deposit holders’
having expectations of a higher rate of return. Rate of return risk differs from interest rate risk
in that IBIs are concerned with the result of their investment activities at the end of
investment-holding period. IBIs may be under market pressure to pay a return that exceeds
the rate that has been earned on assets financed by PLS deposit holders when the return on
assets is under-performing as compared with competitors’ rates. IBIs may decide to waive
their rights to part or their entire Mudarib share of profits in order to satisfy and retain their
fund providers and dissuade them from withdrawing their funds. Displaced commercial risk
derives from competitive pressures on IBIs to attract and retain investors. This category
comprises of two guiding principles i.e., IBIs shall:
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• establish a comprehensive risk management and reporting process to assess the
potential impacts of market factors affecting rates of return on assets in comparison
with the expected rates of return for PLS deposit holders.
• have in place an appropriate framework for managing displaced commercial risk,
where applicable.
When calculating a rate of return, IBIs shall employ a gapping method for allocating
positions into time bands with remaining maturities or repricing dates, whichever is earlier.
Fixed and floating rate assets of IBIs will be classified according to their receivable dates
because the returns on these receivables represent the fund providers’ direct and beneficial
ownership of the assets. Actual cash flows may indicate a gap for a given time band, affecting
the rate of return for that period. Depending on the complexity and the nature of their
business operations, IBIs may employ techniques ranging from simple gap to advance
simulation or dynamic approaches to assess future cash flow variability and net income. The
estimates derived from selected approaches may provide acceptable approximations of
periodic future earnings’ variability; hence, the outcomes will yield different levels of
expected returns to PLS deposit holders.
Operational Risk: IBIs are exposed to risks arising from failures in their internal controls
involving processes, people and systems. They are also exposed to reputational risk arising
from failures in governance, business strategy and process. Negative publicity about the IBI’s
business practices, particularly relating to Shariah non-compliance in their products and
services, could have an impact upon their market position, profitability and liquidity. This
category comprises of two guiding principles i.e.,
• IBIs shall have in place adequate systems and controls, including Shariah Advisor,
to ensure compliance with Shariah rules and principles, and they shall also have in
place appropriate mechanisms to safeguard the interests of all fund providers.
• Where PLS deposit holders’ funds are commingled with the IBIs’ own funds, the
IBIs shall ensure that the bases for asset, revenue, expense and profit allocations are
established, applied and reported in a manner consistent with the IBIs’ fiduciary
responsibilities.
IBIs shall also incorporate possible causes of loss resulting from Shariah non-compliance and
failure in their fiduciary responsibilities. These risks expose IBIs to fund providers’
withdrawals, loss of income or voiding of contracts leading to a diminished reputation or
limitation of business opportunities. Moreover, a reliable IT system is a must for profit
sharing mechanism, failure of which may lead to Sharia non-compliance risk. The bank
should identify key risk indicators and should place key control activities like Code of
Conduct, Delegation of authority, segregation of duties, succession planning, mandatory
leave, staff compensation, recruitment and training, dealing with customers, complaint
handling, record keeping, MIS, physical controls etc.
Furthermore, they should also identify investing activities that contribute to investment
returns and taking reasonable steps to carry on those activities in accordance with the IBIs’s
fiduciary and agency duties and to treat all their fund providers appropriately and in
accordance with the terms and conditions of their investment agreements. The allocation of
assets and profits between the IBIs and their PLS deposit holders will be managed and
applied appropriately to PLS deposit holders having funds invested over different investment
periods. IBIs shall also adequately disclose information on a timely basis to their PLS
deposit holders and the markets in order to provide a reliable basis for assessing their risk
profiles.
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