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Islamic financial institutions' risk profiles differ from those of conventional banks
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LIMASSOL - 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, says Moody's Investors Service 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," says 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. Moody's notes that, 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) theimportance 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.

Notwithstanding the IFSB's endeavour to provide the Islamic banking industry with a set of guidelines towards best-practice risk management, Moody's believes that a number of additional risk issues at IFIs deserve further examination. This view stems from:
(i) IFIs' relatively short track record (modern Islamic banking has been in existence for only three decades, and many Sukuk products less than a decade);
(ii) the fact that most Islamic banks are active in the developing world where transparency,  corporate governance and risk management at large are still works in progress; and
(iii) the shortage of skilled risk management professionals familiar enough with the Shari'ah-compliant banking universe.

The purpose of the report is precisely to define those elements that differentiate IFIs in terms of their risk profiles.

Here, Moody's draws three main conclusions: (i) in IFIs' financing and investment contracts, risk categories of different natures are often entangled, a constraint mitigated by the naturally strong asset collateralisation of their portfolios; (ii) balance-sheet management - including liquidity, investment, asset-liability management (ALM) and capital management -  constitutes a critical field where IFIs face a series of specific challenges that are difficult to cope with; and (iii) specific non-financial risks make it necessary for IFIs to build on, and adhere to, strong corporate governance frameworks.

"Given the importance of risk management in our rating analysis, especially for emerging market institutions whose systems may be lesswell 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," says Hassoune

 
 
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