2012

Final-Term Project

PRESENTED TO:
Prof. Shahid Ghuri

PRESENTED BY:
Systematic risks
(Business environmental,
Name: Attiq-Ur-Rehman institutional, regulatory)
Roll no.: 12103 In Islamic financial
institutions
Course: M.Phil C&F
(Risks, challenges and
Semester: 2nd (Fall 2011) mitigation tools)

Superior University
Lahore.
 Systematic risks
(Business environmental, institutional, regulatory)
In Islamic financial institutions
(Risks, challenges and mitigation tools)

Introduction:
In every Islamic business there should be the risk factors and threats to the
business, because without risk that business does not consider a Halal business due to
Islamic prospective. So in this paper I am going to discus about the systemic risks in
Islamic financial institutions, such like business environmental risk, institutional risk and
regulatory risk. As for as concern the systemic risk is usually related to the financial
based risks and this type of risk is affected by the all other types of risk.

However in Islamic financial institutes there is not only restriction upon the
interest based profit, even that there is other Shariah restrictions are also exist in
Islamic finance model, such like ethical standards etc, so if we do not follow these
principles that may increase the chances of elimination of the business or financial
institutes from the competing market and the business firm can be shutdown.

So therefore if we take some effective measures to overcome the systemic risk in

Islamic financial institutions than we could have a good control on the business activities
and can compete the well growing international markets.

Here in this article I will talk about the factors of systemic risk in which I’ll
Discussing about the main risks (such as business environmental, institutional and
regulatory risks) of Islamic banks or financing institutes, identifying the true risk factors,
strategies to minimizing the risk or risk factors and also will talk about the risk’s
challenges and mitigation tools.
 There is a short history of Islamic banking, so may there is a lot of space in this
field of research and the growth rate of Islamic banks or financial institutes is boosting,
so this research will be an interesting one for the people of this field.

Literature Review:

N. Kayed and M. Mohammed (2007): discussed about the unique risks of the
Islamic finance and in his article they also focused upon the systemic risks of the
Islamic financial model and in Islamic finance. They quoted the following definition of
risk in his article, “Risk… is simply a measure of uncertainty, the chance that some
event will have an impact on objectives. Risk is most commonly thought of as having
negative consequences -harm, loss, danger, and hazard- when in fact it may just as
easily involve opportunities (The Institute of Internal Auditors, 2001: 1)”. They examined
about the unique attributes of the systemic risk and also described the effective
systemic risk management model in which they described that the Mega External
Environment Factors, Task Environmental Factors and Internal Environmental Factors
are having impacts on the Market, Liquidity, Credit and Operational Risks and further
more that risks are playing the significant role in systemic risk and also discussed about
the sources (such like the Interest free Islamic Financial System, Profit and Loss
Sharing Instruments, Scanning the Environmental Factors and Islamic Financial
Principles to mitigate the systemic risks of the Islamic financial institutes. Finally they
conclude at the end of his research paper that “a result managing systemic risk which,
does not be aware of national borders or work in definite patterns, is measured as being
one of the most aggressive challenges confronting financial systems around the globe.
In his paper they argued that although Islamic financial system is not immunized
adjacent to systemic risk, which is a product of different local and international issues of
the financial system, the Islamic financing system has a built in system that minimizes
and protects from critical penalties of such risk”.

Billio Monica et. al (2011): discussed about the economic measures of systemic
risk, they defined systemic risk as “any set of conditions that threatens the solidity of or
public assurance in the financial system”. They used Principal Components Analysis,
Linear Granger Causality Tests and Nonlinear Granger Causality Tests to analyze the
data. They used the individual hedge fund data from the TASS Tremont database. The
researchers also used the September 30, 2009 snapshot of the data, which includes
8,770 hedge funds in both Live and Defunct databases. The researchers used data for
individual banks, broker/dealers, and insurers which they obtained from the University of
Chicago’s Center for Research in Security Prices Database, from which they select the
monthly returns of all companies with SIC Codes from 6000 to 6199 (banks), 6200 to
6299 (broker/dealers), and 6300 to 6499 (insurers). After applying all the planned tests
or methods on the data the researchers finally described that “they suggest for
determine systemic risk ultimately via econometric techniques such as principal
components analysis and Granger causality tests. These measures appear to confine
exclusive and special facets of such risk. Principal components analysis provides them
a wider vision of associations among all four groups of financial institutions”.
Furthermore, on the present sample period, researcher’s experimental findings
recommend that “the banking and other financing organizations may be even more vital
sources of systemic risk than other parts, which is reliable with the subjective evidence
from the current financial crisis”.

Lahmann and Kaserer (2011): discussed about the systemic risk in his research
paper that while Systemic risk and systemic importance are universal concept in the
current conversation on banking regulation but there is so far no conformity on the
concepts for their dimension. The focus of this research for analyzes the systemic risk in
the global financial system and regional sub systems. For the collecting data the
researchers were select bank holding organizations along with the following data
accessibility criteria: firstly at least 500 daily CDS spread observations are available
since October 1st, 2005, secondly publicly available equity prices and thirdly publicly
available liability data. By applying these data availability criteria they obtain a global
sample of 83 banks from 28 countries covering the following four regional sub samples:
America (12 banks), Asia Pacific (24 banks), Europe (38 banks), Middle East and
Russia18 (9 banks). The sample period selected from October 1st, 2005 to April 30th,
2011. In this paper they used the ESS technique or methodology and derive the
expected systemic shortfall (ESS) indicator for the measurement of systemic financial
sector risk. In this research paper the researchers can’t approach to a certain or definite
conclusion but they finally described that the relative systemic risk involvement of
individual banking groups is generally determined by their size, provided that a
uncertain verification of the common ‘too big to fail’ statement. They described that they
added to the continuing discourse relating to the regulation of systemically vital financial
institutions by telling the use of the bank definite relative contributions to the ESS
indicator as determine for a bank’s systemic value. By applying a systemic risk
contribution threshold of 1 percent to the consequences for the comprehensive sample
they find that there are twenty three worldwide systemically key banks. Finally they
recommend that regional and national regulators deem to applying similar metrics to the
banks under their accountability. Further more the researchers said that the extra
endeavor requires to be undertaken in order to develop an operational strategy
structure for the parameter of systemically significant financial organizations beneath
the umbrella of the Basel III banking regulation.

Ahmed Habib (2009): talked about the risks for the Islamic finance with respect to
the financial crises in his study so he also discussed about the systemic risk of the
Islamic financial institutions. The author said “that a problem started with credit risks
soon created liquidity and market risks that created systemic risks. This research paper
has identified some policies and proposals at the institutional, organizational and
product levels that can reduce risks and prevent financial meltdown in the Islamic
financial sector. While the focus of the discussion in this paper has been on the failure
of institutional and organizational mechanisms that led to the failure in evaluating and
managing risks, there is a more fundamental lesson to be learnt from the current
predicament. The crisis has revealed the importance of trust in economic transactions in
general and financial transactions in particular. In the case of Islamic finance, trust will
not only be created by having transparent dealings and well-managed risks, but more
importantly by the authenticity of Islamic products”.

Hendricks, Kambhu and Mosser (2006): discussed in detail about the systemic
risk while discussing the Systemic Risk they discussed that “the stability of the financial
system and the potential for systemic risks to alter the functioning of that system have
long been important topics for central banks and for the related research community”.
While discussing systemic risk in banking sector the researchers said that “the
distinction between illiquidity and insolvency is one that occurs repeatedly in
discussions of systemic risk, a concern that ineffective public policy choices can serve
to generate systemic risk. While the liquidity based contagious run model of systemic
risk applies very directly to banks, it also has relevance to other kinds of institutions.
Here discussed another feature of today’s financial system that works to reduce
systemic risk is the replacement of bank deposits by mutual fund shares as an
investment vehicle for households. Clearly, traditional financial models of systemic risk
cannot readily capture the type of systemic risk that arises from the potential for critical
points of failure to lead to broader disruptions in the system. Finally, the global scale of
large banks and securities firms and some major investors has expanded the channels
that can transmit systemic risk”.

Zaki, Sattar and Manzoor (2011): has talked about the risk mitigation in Islamic
finance so in this paper they discussed about the suggestions, policies and procedures
for risk mitigation in Islamic finance by proposing a regulatory model which highlights
different pre requisite policies mandatory for effective risk management. This basal
study circles around the literature relating to risks, risk management approaches and
risk mitigation policies used as risk mitigation tools. They collected data for this study
through primary and secondary sources. They collected Primary data through
interviewing Islamic finance professional including Islamic bankers. The interviews were
scheduled as formal and informal both for the exploration of the data and research
problem. The major part of the data consisting of secondary sources, were collected
through research journals, internet and relevant books. They used the regulatory model
for risk mitigation in Islamic finance. They concluded his study as follow: “Interest in
financial activities is believed to be the primary reason for the crisis; meanwhile Islamic
economic system has emerged as a replacement of orthodox interest based system.
But the nature and functioning of Islamic financial institutions no doubt have shown
stability but they are questioned because of unique risks which are continuous threats
for these institutions. Therefore in order to sustain long term stability Islamic financial
institutions need to mitigate the unique risks effectively. The results show that three
major policies being the variables of the study provide bases for effective risk mitigation
and purport a regulatory model which after achieving a proper risk mitigation framework,
sustains long term stability”. Finally the researchers recommended that “the Islamic
financial institutions should make sure that risk management practices being carried out
are fully furnishing the goal of long term stability. Thus these institutions should follow a
risk mitigation and management approach by having all the aspects in view in terms of
policy making”.

Khan and Ahmed (2001): discussed about the risk management and also
focused upon the issues of Islamic financial industry and systemic risk. Specifically the
researchers described objectives “that Presenting an overview of the concepts of risks
and risk management techniques and standards as these exist in the financial industry,
discussing the unique risks of the Islamic financial services industry and the perceptions
of Islamic banks about these risks, reviewing the main regulatory concerns with respect
to risks and their treatment with a view to draw some lessons for Islamic banks,
discussing and analyzing the Shariah related challenges concerning risk management
in the Islamic financial services industry and presenting policy implications for
developing a risk management culture in Islamic banks”. They discussed about
systemic risk that “Systemic risk is the probability that failure of even a small bank could
result in the contagion effect and the whole payments system could be disrupted. This
could lead to a financial crisis, decline in the value of assets in place, impairing growth
taking capabilities of the economy, creating unemployment, decreasing economic
welfare and even causing social and political instability”. They used the Core Principles
and Assessment Methodology of Banking Supervision in his research paper. Finally
they concluded that “Islamic financial industry has come a long way during its short
history. The future of these institutions, however, will depend on how they cope with the
rapidly changing financial world. Majority of the risks faced by conventional financial
institutions such as credit risk, market risk, liquidity risk, operational risk, etc., are also
faced by the Islamic financial institutions. However, the magnitudes of some of these
risks are different for Islamic banks due to their compliance with the Shariah. In addition
to these risks commonly faced by traditional institutions, the Islamic institutions face
other unique risks. These unique risks stem from the different characteristics of the
assets and the liabilities. Consequent on the common or unique nature of risks faced by
the Islamic financial institutions, the techniques of risk identification and management
available to these institutions are of two types. The standard traditional techniques that
are not in conflict with the Islamic principles of finance are equally applicable to the
Islamic financial institutions”.

Ibrahim, Ismail and Zabaria (2012): discussed about the risk and performance in
Islamic banking. The main objective of this research is “to explore the relationship
between disclosure, risk and performance among Islamic banking. In this research, the
researchers also test one’s variable are endogenous or exogenous, whereby these
three variables will be influenced simultaneously. The methodology strategies were
based on Hashem Dezhbakhsh and Rubin (2003), but their modeling strategies were
drawn on Al-Tuwaijiri et. al (2003) which were constructed by the equations of the
estimation their relationship using Simultaneous Equations Model (SEM). The data were
collected from 11 banks’ annual report from 2002 until 2006. The sample selection
consists of Islamic commercial banks and the commercial banks that are operated in
Islamic banking scheme (SPI) and in this study there are 51 samples selected by the
researchers. After the complete analysis on the data, finally they found that the level of
leverage among banks were positively significant with the disclosure. This situation
should occur in banking operations since disclosure of level of leverage may be
positively related to disclosure if they indicate that management intends to address a
bank’s leverage. Indirectly, this situation will give more burdens to banking systems.
Therefore, banks must reduce their risk-taking to ensure that their level of leverage
becomes low. So, as the relative to risk taking, banks must create more modes and
instruments in order to obtain more results”.
Conclusion:

This literature review enables me to determine the systematic risk in Islamic

financial institutions and also enhanced the knowledge about the mitigation tools,
challenges and the factors that can be counter the risk factors in Islamic financing
institutions especially in banks.

So this review of works has also recognized that “Islamic financial industry is subject to
exclusive forms and types of risk, mainly systemic risk, and other related sources of risk
(i.e., market, credit, liquidity, business environmental, institutional, regulatiory and
operational risks), comprises a different factor of the worldwide financial industry. It
further argued Muslim scholars, practitioners, and regulators to accept the challenge by
undertaking an in-depth systematic exploration of the Islamic financial vision in order to
devise Al Shariah compliant protective measures and functional preventive mechanisms
in dealing with various types of financial risks based on the following principles: the
prohibition of interest-based financing at all levels and in all forms and shapes; the true
and honest implementation of the PLS contracts; and Maintaining (appropriate)
minimum capital adequacy requirements for IFIs that reflect the level of risk undertaken
by these institutions”.

References:
 Dr. Rasem N. Kayed and Dr. Kassim M. Mohammed (2007): Unique Risks of
Islamic Modes of Finance: Systemic, Credit and Market Risks, Journal of Islamic
Economics, Banking and Finance, Volume-5 Number-3.
 Monica Billio, Mila Getmansky, Andrew W. Los and Loriana Pelizzon(2011):
Econometric Measures of Systemic Risk in the Finance and Insurance Sectors,
Electronic copy available at: http://ssrn.com/abstract=1571277.
 Wolfgang Lahmann and Christoph Kaserer (2011): MEASURING SYSTEMIC
RISK AND ASSESSING SYSTEMIC IMPORTANCE IN GLOBAL AND
REGIONAL FINANCIAL MARKETS USING THE ESS-INDICATOR, Working
Paper, this version: July 29, 2011.
 Habib Ahmed (2009): Financial Crisis: Risks and Lessons for Islamic Finance,
ISRA International Journal of Islamic Finance Vol. 1, Issue 1, 2009.
 Darryll Hendricks, John Kambhu, and Patricia Mosser (2006): Systemic Risk and
the Financial System Background Paper, NAS-FRBNY Conference on New
Directions in Understanding Systemic Risk, Federal Reserve Bank of New York.
 Abdul Rehman Zaki, Abdul Sattar and Muhammad Mazhar Manzoor (2011): Risk
Mitigation in Islamic Finance through Policies and Regulatory Model- A Way to
Long-Term Stability, International Research Journal of Finance and Economics
ISSN 1450-2887 Issue 68 (2011), © EuroJournals Publishing, Inc. 2011.
 Tariqullah Khan and Habib Ahmed (2001): Risk management an analysis of
issues in Islamic financial industry, ISLAMIC DEVELOPMENT BANK ISLAMIC
RESEARCH AND TRAINING INSTITUTE, OCCASIONAL PAPER NO. 5,
JEDDAH - SAUDI ARABIA, 1422H (2001).
 Wan Hakimah Wan Ibrahim, Abdul Ghafar Ismail and Wan Najihah Wan Mohd
Zabaria(2012): Disclosure, Risk and Performance in Islamic Banking: A Panel
Data Analysis, International Research Journal of Finance and Economics ISSN
1450-2887 Issue 72 (2011), © EuroJournals Publishing, Inc. 2011.