Risk management is at the heart of banks’ financial intermediation process. Islamic financial institutions, like their conventional banking peers, face many challenges in adequately defining, identifying, measuring, selecting, pricing and mitigating risks across business lines and asset classes, albeit that the actual risks may differ, Moody’s Investors Service said in its special report entitled “Risk Issues at Islamic Financial Institutions”.
“Risk management has assumed utmost importance at a time when complexity and volatility in financial markets have become both differentiating factors building competitive advantages and sources of risk entanglement,” said Anouar Hassoune, a Moody’s Vice President/Senior Credit Officer and author of the report.
Basel II and widespread write-downs have highlighted the importance of sufficient capital adequacy and, more importantly, set a framework for improving the overall risk management architecture in banks. In rating financial institutions, Moody’s places great emphasis on risk management frameworks and corporate governance, particularly in fast-growing emerging markets where such factors tend to attract lower scores than in more mature economic and business environments.
Islamic financial institutions (IFIs) are no exception. The Islamic Financial Services Board (IFSB) has recently published a standard for risk management in Islamic institutions, and this forms the basis for all discussions between Moody’s analysts and bank management in this area. Islamic banks’ balance-sheet structures indicate that there is a great diversity of classifications on both the asset and liability side.
Such variety affects the ease of comparison between both differing Islamic institutions and Islamic institutions and their conventional peers, making it difficult to apply just one appropriate risk management approach. Therefore, the IFSB has prudently adopted a principles-based approach.
The IFSB standard lists 15 guiding principles for risk management in IFIs.
Overall, the main differences between these principles and those appropriate for a conventional bank relate to five key areas: (i) the range of asset classes found in Islamic banks; (ii) the relatively weak position of investment account holders; (iii) the importance of the Shari’ah supervisory board and the bank’s ability to provide the board with adequate information as well as abide by its rulings; (iv) rate-of-return risk; and (iv) new operational risks.
“Given the importance of risk management in our rating analysis, especially for emerging market institutions whose systems may be less well developed than those of conventional banking peers, the ability of IFIs to build and develop their risk management capabilities will not be without rating implications,” said Hassoune.
