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.

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 profilesinclude 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 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:

• 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.

urthermore, 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.

.