Transcript Document
RISK MANAGEMENT AND CORPORATE GOVERNANCE IN ISLAMIC FINANCIAL INSTITUTIONS
ZULKIFLI HASAN HAWKAMAH, THE INSTITUTE OF CORPORATE GOVERNANCE 26 TH MARCH 2009
CONTENTS
Introduction Case Study: Closure of Ihlas Finance, due to Poor Corporate governance (CG) What is CG?
Why it is important to Islamic risk management system?
Elements of Good CG in IFIs Risk Management in IFIs Roles of Board of Directors (BOD) and Senior Management Roles of Shari’ah Board Concluding Remarks
Financial Distress and Failure of Ihlas Finans
Financial Crisis in Turkey 2000-2001. One Islamic institution Ihlas Finans (the first domestic IFI in Turkey) was closed during the crisis while the other five Islamic banks were survived.
Ihlas Finans is a special finance house established in 1995 and was a subsidiary of Ihlas Holdings.
The BRSA cancelled the license of Ihlas Finans on 10 th February 2001.
Factors
Accumulation of bad debt- Politically motivated lending and lending to connected business. Finance the businesses of its parent company, Ihlas Holdings.
Lax Regulation- Law on full guarantee of the bank deposits offered by the State made banking a lucrative business for the corrupt entrepreneurs with political connections who set up banks that siphoned off money.
Major proportion of the investment was an illiquid assets and projects as compared to other domestic and foreign commercial banks who could hold very liquid government securities.
Failures in CG and lack of internal checks and balances: Control failure, Management failure and regulatory failure.
A rubber stamp board of directors, Lax Attitude towards governance, Some members appointed to the board did not have requisite experience, Only one institutional member i.e. IDB as minority shareholder and thus it was easy to manipulate the Board Board members are ignorant of financial and economic facts and working of the company , board members are not motivated, Some board members had conflict of interest owing to their dual role as board members as well as clients of finance from Ihlas Finans Holdings Control Failures The Bank staff lack relevant experience and training
The bank is run on trust without proper systems of internal control
Not preparing enough for changing regulations, No Crisis Management Plan, Decision making during crisis was ad-hoc and uncoordinated internally Connected Lending and Investment Concentration, Executive Selection Hired a senior executive from a previously failed bank Management Failures Allowing Withdrawal from Investment Accounts, Failure to manage liquidity risk Indulge in fraudulent practices, some of the mudharabah agency financing was done in the name of fictitious parties while the funds were used for solving internal financial problems
Drastic application of rules Lax Supervision Lacuna in Regulatory Failures supervision of law Unclear scope of deposit protection law and confusion on who is the authority
What is CG?
CG is the system by which business corporations are directed and controlled .
CG specifies the distribution of rights and responsibilities among different participants in the company such as BOD, Shari’ah board, managers, shareholders, and other stakeholders.
A concept of CG in IFIs presents distinct characteristics and features in comparison with the conventional system as it goes beyond the financial return whereby it covers the element of ethic, Shari’ah and beliefs (aqidah). Shari’ah board plays significant role to supervise , oversea and advise the shari’ah aspects of the corporation.
Why CG is important for risk management in IFIs?
Hypothesis 1: Weak CG may lead to ineffective risk management system.
Hypothesis 2: Strong commitment to good CG will improve and strengthen risk management system in IFIs
Case Study: Ihlas Finans was closed in 2001 due to poor CG while the other five Islamic banks in Turkey were survived because of better CG.
Existing Studies
Well governed UK companies posted 18% higher returns than those with poor governance after adjusting for risk (ABI Research Paper 7: 2008); Well governed firms in Korea have been found to trade at a premium of 160% to poorly governed firms (Black, B Et al: 2004); A study of S&P 500 firms showed that companies with strong or improving CG practices outperformed those with poor or deteriorating governance practices by about 19% over a 2-year period (Grandmont, R Et al: 2004).
A worst-to-best improvement in CG predicted an astronomical 700-fold increase in firm value among Russian firms (Black, B: 2001).
The Six Elements of Good CG in IFIs
Good Board Practice Sound Shari’ah Governance system Disclosure and Transparency Commitment to Good CG Shareholders Right Control Environment and Processes
Risk Management in IFIs
Certain types of risks are of equal concern to all financial institutions, including IFIs.
IFIs face additional risks that emanate from the unique characteristics of Islamic finance transactions, along with risks associated with the real or perceived non-compliance of Shariah principles.
The survival and success of IFIs depends on the efficiency in which they can manage its risks and how they will manage different risks arising from their operations.
How good CG may improve Risk Management System?
IFIs 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 and, where appropriate, to hold adequate capital against these risks. The process shall take into account appropriate steps to comply with Sharī`ah rules and principles and to ensure the adequacy of relevant risk reporting to the supervisory authority.
Risk Management in IFIs
Board and Senior Management
• Credit Risk • Equity Investment Risk • Market Risk • Liquidity Risk • Rate of Return Risk • Operational Risk
Shari’ah Board
• Shari’ah Non-compliance Risk
Roles of Board and Senior Management
Approve the risk management objectives, strategies, policies and procedures ; Ensure the existence of an effective risk management structure for conducting IFIs’ activities, including adequate systems for measuring, monitoring, reporting and controlling risk exposures; IFIs shall have in place an appropriate body, in accordance with sound principles of CG, to oversee that all products and activities comply with Sharī`ah rules and principles as approved in each jurisdiction .
Cont…
Approve limits on aggregate financing and investment
exposures to avoid concentration of risk and, ensure that IFIs hold adequate capital against these exposures.
Review the effectiveness of the risk management activities periodically and make appropriate changes as and when necessary.
Execute the strategic direction set by the BOD on an ongoing basis and set clear lines of authority and responsibility; Senior management shall ensure that the risk management function is independent from the risk taking activities and is reporting directly to the BOD or senior management outside the risk-taking unit.
Types of Risk Credit Risk Equity Investment Risk Market Risk Liquidity Risk Rate of Return Risk Operational Risk Roles of BOD and Senior Management
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Strategy for financing and recognize the potential credit exposures.
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Carry out due diligence review
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Appropriate methodologies for measuring and reporting credit risk exposure
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Shariah-compliant credit risk mitigating techniques
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Strategy for risk characteristics of equity investments
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Appropriate valuation methodologies
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Establish exit strategies in respect of equity investment activities
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Appropriate framework for market risk management in respect of all assets held
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Appropriate liquidity management framework
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Able to assume that liquidity risk commensurate with their ability to have sufficient recourse to Shariah-compliant funds to mitigate such risks
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Comprehensive risk management and reporting process to assess the potential impacts of market factors affecting rates of returns on assets in comparison with the expected returns for IAH
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Adequate system and controls to ensure Shariah compliance
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Appropriate mechanism to safeguard the interest of all fund providers.
Roles of Shari’ah Board
IFIs shall have adequate system of controls including Shari’ah governance (SG) system.
SG is a set of institutional and organizational arrangements through which IFIs ensure that there is independent oversight of Shari’ah compliance.
IFIs shall have in place a Shari’ah board (SB) to review and ensure that all financing proposals are Shari’ah compliant at all times.
Internal/External Shari’ah review unit to assist the SB for Shari’ah-compliance purpose.
How Shari’ah governance complements the existing corporate governance?
Functions Typical Financial Institution Exclusive to IFIs Governance Board of Directors Control Compliance Internal Auditor and External Auditor Regulatory and financial compliance officers, unit or department Shari’ah board Internal Shariah Review Unit/ External Shari’ah review Internal Shari’ah compliance unit
Shari’ah Non-Compliance Risk
IFIs are exposed to risk relating to Shari’ah non compliance risks and also to reputational risk. These risk exposes IFIs to fund providers’ withdrawals, loss of income or voiding contracts leading to a diminished reputation or the limitation of business opportunities.
IFIs shall at all times comply with the Shari’ah rules and principles as determined by the SB with respect to products, activities and contract documentation.
IFIs shall undertake a Shari’ah compliance review. IFIs shall keep track of income not recognized arising out of Shari’ah non-compliance.
Some Impact of Shari’ah Non-Compliance Risk
Slowdown of global Sukuk issuance.
By the end of 2008, global Sukuk issuance had declined by more than 50% compared to 2007.
Chairman of the AAOIFI Shari’ah board- criticized a common form of sukuk that apparently violates the Sharia compliant principles surrounding risk and profit-sharing. He estimated that up to 85% of Gulf Sukuk structures were not Shari’ah-compliant. AAOIFI made a recommendation to Islamic finance market participants to refrain from issuing Sukuk structures that have a purchase undertaking or guarantee from the Sukuk issuer to repurchase at a future date at a specific price.
Elements of Good Shari’ah Board
Independence
Clear Mandate and Responsibility
Competence Acceptable fit and Proper Criteria Sound Code of Ethics and conduct Well-defined Operating Procedures Transparent and Disclosure
Concluding Remarks
Good CG is crucial in providing effective risk management system.
Certain types of risks are of equal concern to all institutions offering financial services, but there are certain specific risks which are exclusive to IFIs.
Board of Directors and Senior management have specific roles in relation to risk management objectives, strategies, policies and procedures in order to mitigate all types of risks.
Shari’ah board is more concerned on the aspect of Shari’ah non-compliance and reputational risks.
IFIs need for a set of best practices of corporate governance and effective risk Management that give practical effect to managing the underlying risks.
References Ali, Salman Syed (2007). Financial Distress and Bank Failure: Lessons from Closure of Ihlas Finans in Turkey , Islamic Economic Studies, Vol. 14, No. 1 & 2, Aug. 2006 & Jan. 2007, pp: 1-52.
ABI Research Paper 7. (February 2008). Governance and Performance in Corporate Britain . London: The Association of British Insurers.
Black, B. S. Jang, H and Kim, W (2004). From Korea.
Predicting Firms CG Choices: Evidence University of Texas Law School Working Paper No. 39, August.
Black, B. (2001). The CG Behavior and Market Value of Russian Firms . Emerging Market Review, Vol. 2, March.
Grandmont, R, Grant, G. and Silva, F. (2004). Beyond the Numbers- CG: Implications for Investors , (Deutsche Bank, April 1).
Hijazi, Faisal. (2009). Global Sukuk Issuance: 2008 Slowdown Mainly Due to Credit Crisis and Some Impact on Shari’ah compliance issues. International Structured Finance Special Report. IFC and Hawkamah. (2008). A Corporate Governance Survey of Listed Companies and Banks Across the Middle East & North Africa . Washington: IFC.
IFSB Exposure Draft Guiding Principles on Shari’ah Governance System.
IFSB Guiding Principles of Risk Management For Institutions (Other then Insurance Institutions) Offering Only Islamic Financial Services.