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IN ISLAMIC BANKIN ISLAMIC BANK
MD AROP OTHMANMD AROP OTHMANRISK MANAGEMENT DIVISIONRISK MANAGEMENT DIVISION
BANK ISLAM MALAYSIA BERHADBANK ISLAM MALAYSIA BERHAD
15 NOVEMBER 200715 NOVEMBER 2007
Bank Islam reserves all propriety rights to the contents of this Presentation. No part of this Presentation may be used or reBank Islam reserves all propriety rights to the contents of this Presentation. No part of this Presentation may be used or reproproduced in any formduced in any form
w ou an s am s pr or wr en perm ss on.w ou an s am s pr or wr en perm ss on.
This Presentation is provided for information purposes only. Neither Bank Islam nor the Presenter makes any warranty, expresThis Presentation is provided for information purposes only. Neither Bank Islam nor the Presenter makes any warranty, expressedsed or implied, noror implied, nor
assumes any legal liability or responsibility for the accuracy, completeness or currency of the contents of this Presentationassumes any legal liability or responsibility for the accuracy, completeness or currency of the contents of this Presentation..
STRICTLY PRIVATE & CONFIDENTIAL
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ContentContent
Introduction to Risk Management
Risk Management for Islamic Banks
Principles of Risk Management
Risk Mana ement in Bank Islam
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Concept of r isk management
Definition of risk
Risk management process
Im act of oor risk mana ement
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Concept of risk management in IslamConcept of risk management in Islam
Text in Al-Quran
O my children, do not enter the capital of Egypt by one gate but go into it by
different gates. However, know it well that I cannot ward off you Allahs will for
none other than He has nay authority whatsoever. In Him I have put my trust.
(Surah Yusuf: Verse 67)
a rom rop e u amma s.a.wProphet (peace be upon him) once asked a Bedouin who had left his camel
untied, Why do you not tie your camel? The Bedouin answered, I put my trust
INCEIF-LOFSA WORKSHOP, LABUANPage 4
. ,
trust in God.
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What is r isk?What is r isk?
Risks are uncer t ain f ut ure event swhich could influence the
achievement of the Banks objectives, including strategic,
operat ona , nanc a an comp ance o ect ves.
Uncer t ain f ut ure event scould be:
Failure of a borrower to repay a financing
Fluctuation of foreign exchange rates
Fraud, incomplete security documentations, etc
Non-compliance with shariah law and principles
Other events that may result in a loss to the Bank
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What is r isk management?What is r isk management?
Risk management is the processby which various risk
exposures are
(1) identified,
(2) measured/assessed,
,
(4) reported and monitored.
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Lesson learnt from poor r isk managementLesson learnt from poor r isk management
1. Barings Bank
- Nick Leeson singled handedly destroyed a bank
. um tomo
- The trader hid the losses while trading in the copper futures
- The company loss USD2.6 b
3. Daiwa Bank
- The trader hid the losses while trading in bond market- .
4. Orange County
- There was lack of management control over the trader
- The company lost USD1.69 b in the derivatives market
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Islamic banking business activities
Risks inherent in Islamic banking business
Uniqueness of Islamic banking
Risk issues for Islamic banks
Shariah non-compliance risk
Rate of return risk/Displaced Commercial risk
Inventor risk
Completion risk
Risk transformation at different stages of contract
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Islamic banking business act ivit iesIslamic banking business act ivit ies
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Balance sheet of Islamic bankBalance sheet of Islamic bank
Prof it & Loss
Islamic bankCustomer Depositors
Revenue Dividen/Hibah
Financing Deposit
Balance SheetAssets Liabilit ies
-
Murabahah/Ijarah/Istisna/Salam
Prof it sharing t ransact ions Investment accountsMudharabah/Musharakah Mudharabah
Fee based services Special investment accounts
Mudharabah/Musharakah
Equity
Off Balance Sheet
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Rest ricted investments Direct investors
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Risk profi le of Islamic bankRisk profi le of Islamic bank
DisplacedCommercial
risk
Shariahnon-compliance
riskue
Rate of ret urn r isk EquityInvestmentrisk
U
ni
Islamic bank
Operationalrisk
CreditRisk
ric
Liquidity riskMarket
risk
Gen
St rategic Legal Fiduciary Reputat ion Transparency Regulatory compliance
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Generic risks for banksGeneric risks for banks
Types of r isks Def init ion
Credit r isk The potential that a counterparty fails to meet its
of credit-related contract
Market r isk The potential impact of adverse price movements such as, ,
the economic value of an asset
Liquidi ty risk The potential loss arising from the Banks inability either tomeet ts o gat ons or to un ncreases n assets as t ey
fall due without incurring unacceptable costs or losses
Operational r isk The potential loss resulting from inadequate or failed
internal processes, people and system or external events
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Risks transformation for financing of assetsRisks transformation for financing of assets
Even generic risks are not st raight forward in Islamic banking
For financing that involves financing assets eg Murabahah, Salam,Ist isna and I arah the risks of f inancin ma t ransform from credit to
market and vice versa at dif ferent stages of cont ract Hence capit al requirement needs to take into account both t he credit
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Risk t ransformat ion under Murabahah & MPORisk t ransformat ion under Murabahah & MPO
ura a a an se s asse s a rea y owne o cus omer a cos +
Murabahah Purchase Orderer (MPO) Bank sells assets it acquires to customer at
cost + based on promise to purchase (PP) by customer
Type of cont ract Stage of cont ract Credit r isk Market r iskMurabahah and
-Asset available for sale (asset on - X
Murabahahpurchase order
Asset is sold to and payment is due
from customer
X -
settlement
- -
Binding Murabahah
Purchase Order
Asset available for sale (asset on
balance sheet
X -
Asset is sold to and payment is due
from customer
X -
- -
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settlement
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Risk t ransformat ion under Ij arah & IMBRisk t ransformat ion under Ij arah & IMBIjarah Bank owns the assets whilst transferring the right to use the asset to lessee. Liabilities & risks pertaining to
Type of cont ract Stage of cont ract Credit r isk Market r isk
e asse s orn y an
IMB Bank promise to transfer the asset by sale or hibah & MUST be separately expressed and independent of
underlying Ijarah
Operat ing Ij arah Asset available for lease (prior tosigning of a lease contract)
- X
Upon signing a leasing contract and X Xthe asset is available for lease
Maturity of contract term and the
leased asset is returned to the bank
- X
Ijarah MuntahiaBittamleek
Asset available for lease (prior to
signing of a lease contract)
- X
Upon signing a leasing contract and X -
the asset is available for leaseMaturity of contract term and the
leased asset is sold and the - -
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owners p o asse s rans erre o
the customer
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Unique r isks for Islamic banksUnique r isks for Islamic banks
Types of r isks Definit ion
Shariah non-compliance r isk
Risk arises from the failure to comply with the Shariah rules
and principles
Rate of return r isk The potential impact on the returns caused by unexpectedchange in the rate of returns
Displaced Commercialrisk
The risk that the bank may confront commercial pressure to
pay returns that exceed the rate that has been earned on its
assets financed by investment account holders. The bank
its fund providers and dissuade them from withdrawing their
funds.
E uit Investment r isk The risk arisin from enterin into a artnershi for the
purpose of undertaking or participating in a particularfinancing or general business activity as described in the
contract, and in which the provider of finance shares in the
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us ness r s . s r s s re evan un er u ara a an
Musharakah contracts.
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Salient features of Islamic bankingSalient features of Islamic banking
- .
FEATURE WHY?
-
It cannot earn more money by itself withoutputting it into real productive actions.
knowledge (gharar)-free
caused by the lack of knowledge.
3. Gambling (maysir)-free Zero-sum game wherein it just transfers thewealth, not creating new wealth.
4. Not involved in selling or
leasing or partnership in
something is impure or not halal
Religious and ethical value consideration or
public policy.
5. Not in direct conflict withestablished Shariah principles
in muamalah.
To ensure every contract behaves in its propercontext.
This does not negate freedom of contract
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urr ya a - a aqu
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Examples of Shariah issuesExamples of Shariah issues
Completeness of aqad (contract) risk
Murabahah Contract
.
2. Buyer3. Asset to be t ransacted
.
Additional
requirements
1. The original pr ice of the asset is known t o the buyer
2. Transparent in t erms of profi t to be taken by the seller
3. Payment must be made wi th something of legal tender value
4. Not ribawi commodities
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Examples of Shariah issuesExamples of Shariah issues
.
Disclosure of the hibahon the rate board, website etc.
Gift to depositors
Shariah non-compliance fund
.
Guarantee on the capital and return
Maintenance cost on the Mudharabah deposit account
Shariah non-compliance fund
.
Shariah non-compliance fund
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Examples of Shariah issuesExamples of Shariah issues
4. Sale (Bai Inah & BBA)
MPO Ownership of the asset prior to sale aqad
-
The word agree in the aqad
Financing of non-Shariah compliant asset
Financing of asset intended for non-Shariah compliant activities
5. AITAB
Appointment of customer as the Banks purchasing agent prior to Ijarahcontract
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Examples of Shariah issuesExamples of Shariah issues
6. Trade Financing
Commitment fee on the unutilized line
, .
7. Refinancing
Refinancing of encumbered property
8. Recovery
Repossession - BBA
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Implicat ions of Shariah nonImplicat ions of Shariah non--compliancescompliances
Non Financial Impact s Financial Impact s
Against the commands of Allah.
Impediment from Allahs blessing or
Invalidation of contract (aqad)
Non-halal income
ara a
Contravention of the provision of
Islamic Banking Act 1983 (Section
Capital adequacy ratio (CAR) Impact
a ec on
Jeopardize the Banks reputation as
an Islamic bank
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Rate of Return RiskRate of Return Risk
Associated with the management of assets and liabilities
Fixed rate long term assets funded by variable rate short-term liabilities
ovement n enc mar rates may resu t n un prov ers av ng
expectations of a higher rate of return
Subsequently, it may result in displaced commercial risk where due to
market pressure, Islamic bank needs to pay a return that exceeds the rate
that has been earned on its assets.
,
providers which could consequently lead to liquidity risk
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Profit distributionProfit distribution
Income frominvestment
Income fromfinancing
Income fromIMM investing
Less:Net trading income and other income
Financing and investment loss provision
Profit equalisation reserve
Net Distr ibut able Income
Direct expenses
Profit Sharing Ratio
Investment Risk Reserve
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Depositor Islamic bank
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BASEL Commit tee on Banking Supervision
Islamic Financial Services Board (IFSB)
Bank Negara Malaysia
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BASELBASEL
1988 Capital Accord (Basel I) Regulatory based
Set out requirements to calculate capital charge ie the amount of capital to be
One size fits all
Market Risk was incorporated into Basel I
2004 Internat ional Conver ence of Ca it al Measurement and Ca it alStandards (Basel II)
Aims to make capital requirements more risk sensitive
Includes Operational Risk
Bank shall be subject to 3 mutually reinforcing pillar Pillar 1: Minimum Capital requirements
Pillar 2: Supervisory Review Process
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IFSBIFSB
2005 Guiding Principles of Risk Management
2005 Capital Adequacy Standard
orporate overnance
2007 Supervisory Review Process
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IFSB Guiding Principles of Risk ManagementIFSB Guiding Principles of Risk Management
15 guiding principles which cover
General re uirement for an effect ive r isk mana ement rocess 1
Credit r isk (4)
Equity Investment Risk (3)
Liquidity Risk (2)
Rate of Return Risk (2) Operational risk (2)
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IFSB Guiding Principles of Risk ManagementIFSB Guiding Principles of Risk Management
General requirement
Princi le 1.0 IIFS shall have in lace a com rehensive risk mana ementand reporting process, including:
A ro riate Board and Senior Mana ement oversi ht
Identify, measure, monitor, report and control relevant categories of risks
Held adequate capital against risk
Adequate risk reporting to the supervisory authority
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IFSB Guiding Principles of Risk ManagementIFSB Guiding Principles of Risk Management
Shariah non-compliance
Princi le 7.1 IIFS shall have in lace ade uate s stems and controls,including Shariah Board/Advisor, to ensure compliance with Shariah rules
and principles
Requirements:
IIFS shall ensure that they comply at all times with the Shariah rules and
rinci les
IIFS shall ensure that their contract documentation complies with Shariah rules
and principles
IIFS shall undertake a Shariah compliance review at least annually
IIFS shall keep track of income not recognised arising out of Shariah non-compliance and assess the probability of similar cases arising in the future
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IFSB Guiding Principles of Risk ManagementIFSB Guiding Principles of Risk Management
Rate of return r isk
Princi le 6.1 IIFS shall establish a com rehensive risk mana ementframework and reporting process to assess the potential impacts of market
factors affecting rates of return on assets in comparison with the expectedrates of return for investment account holders
Principle 6.2 IIFS shall have in place an appropriate framework for
mana in dis laced commercial risk, where a licable
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IFSB Capital Adequacy StandardIFSB Capital Adequacy Standard
e nee or ramewor
To ensure that Islamic banks can absorb a reasonable level of losses before
becoming insolvent.
To provide protection to depositors and/ or PSIA the higher the CAR, thehigher the level of protection.
To promote stability and efficiency of the financial system by reducing the
likelihood of Islamic banks becoming insolvent.
To ensure that the Islamic banks capital position commensurate with itsoverall risk profile and strategy.
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IFSB Capital Adequacy StandardIFSB Capital Adequacy Standard
IFSB RWCR - St andard Formula
Eligible Capital
Total RWA (Credit + Market Risks) + Operational Risk PSIA isis
> 8.00%
LessLess
RWA funded by PSIA (Credit + Market Risks)
SharingSharing
InvestmentInvestmentAccountAccount
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IFSB Capital Adequacy StandardIFSB Capital Adequacy Standard
IFSB RWCR -Supervisory Discret ion Formula
Eligible Capital
Total RWA (Credit + Market Risks) + Operational Risk
LessLess
RWA funded by Restricted PSIA (Credit + Market Risks)
LessLess
LessLess
[RWA funded by Profit Equalisation Reserve (PER) and Investment Risk Reverse (IRR)
of Unrestricted PSIA (Credit + Market Risks)]
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Risk Management Framework
Organisat ional St ructure
Policy and Guidelines
Enablers
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Risk Management Framework (RMF)Risk Management Framework (RMF)
Providing an architecture that governs the overall risk management
philosophy and strategy
c ng as a oun a on o a ow managemen o r s s o e con uc e mos
effectively in line with the industrys best practices
risk
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C M h d lC M h d l
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Concept & MethodologyConcept & Methodology
SOLAH THE PILLAR OFISLAM
PHILOSOPHY OFSOLAH IN LIFE
BANK ISLAMS RMF
NIYYAH
Pronouncement/ Statement of Solah
MISSION STATEMENT MISSION & OBJECTIVES
Implementation Structure of Solah
RULE OF LAW
STRUCTURE
POLICIES & GUIDELINES
FUNCTIONAL STRUCTURE
Necessary Elements of Solah
RUKUN
RULE OF LAW
PROCEDURE
POLICIES & GUIDELINES
PROCESSESEssential Activities of Solah
QAEDAH
Facilities Required for Solah TOOLS
PROCESSES
ENABLERS
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Facilities Required for Solah
F i l SF i l S
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Funct ional St ructureFunct ional St ructure
BOARD OFDIRECTORS
Other Board
Committees
Board RiskCommittee (BRC)
Constitution
As per BNM guidelinesFunction
Risk Mgmt Oversight and Over-riding
authority for Risk Mgmt
Shariah SupervisoryCouncil (SSC) Board FinancingReview Committee
Managing Director
pprova o u m ss ons
Functional
SHAREHOLDER
MANAGEMENT
Internal AuditDepartment
(BFRC)
FinancingCommittees(FCA, FCB, RFC)
Management RiskControl Committee(MRCC)
Administrative
Other Management
Committees
Business Units
( C , C , C) ( CC)Risk Management Division(RMD)Business Support Units
Market RiskCredit RiskOther Corporate
Support Units
Asset LiabilityCommittee (ALCO)
Credit AnalysisCredit Administration
Business Risk ControlShariah Compliance
Risk
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omp ance
Operational Risk
P li i & G id liP li i & G id li
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Policies & GuidelinesPolicies & Guidelines
Policies for principle risk areas are in place covering areas of credit,market, operational and Shariah compliance
Policies are su orted b Guidelines and further su orted b o erat ionalmanuals to ensure policies are implemented properly
Approving authority
RMF Board
Policy Board
Manual - Stakeholders
All policies, guidelines and manuals are reviewed annually to ensure
consistency and in line with business reality
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C dit i kC dit i k
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Credit r iskCredit r isk
Policy Guidelines
Credit Risk Policy - The policy addressesthe broad credit management framework
1. Pricing Matrix Guidelines
2. Acceptance Let ter Offer Guideline
that covers the objective, strategy,
structure and credit processes in order toestablish the best practices in the
3. Negat ive List Guideline
4. Collaterals Guideline5. Valuat ion Guideline
with the regulatory requirements.
.
7. Sovereign Risk Guideline
8. Consumer Grading Guideline
9. Sectoral Guideline
10. Business Relationship EtiquetteGuideline
11. Watchlist Guideline
. nanc ng rocess u e ne
13. Credit Recovery Guideline
14. Guidelines on Risk Adj usted Pricing forCor orate & Commercial
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Market r iskMarket r isk
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Market r iskMarket r isk
Policy Guidelines
ar e s o cy escr es e s o cyand Analytics, Asset and Liability Management
(ALM) and Middle Office functions of the
Market Risk Department
.
2. Hedging Guideline
3. Mark-to-Market Guideline
4. Rate Reasonabil ity Check Guideline
Trading Book Policy - Addresses market riskfactors which include but not limited to profit
rate or rate of return forei n exchan e
5. Value-at -Risk (VaR) Guidel ine
6. Asset and Liabil ity ManagementGuideline
equity and commodity risks inherent in the
Banks trading and banking books
. ar e s anua roce ures
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Operat ional r iskOperat ional r isk
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Operat ional r iskOperat ional r isk
Policy Guidelines
pera ona s o cy e po cy prov esthe effective and efficient operational risk
management through out the Bank through its
strategies in terms of organization structure,
.
2. Management Awareness and Self-
3. Assessment (MASA) Reporting Guideline
4. Fraud Handlin and Re ort in Guidelineprocess, r s o erance, r s measuremen an
analytic model management information
system
5. Takaful/Insurance Guideline
6. Key Risk Indicators (KRIs) Guideline
7. Outsourcing Guideline8. Operational Risk Management Process for
Information Security Management System
9. Customer Complaint Guideline
.
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Sh i h li i kSh i h li i k
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Shariah compliance riskShariah compliance risk
Policy Guidelines
Shariah Compliance Risk Management 1. Wadiah Contract Guideline.Policy The policy provides the Shariah
requirements applicable throughout theBank in its activities, products and
services in compliance with the Shariah
2. Ij arah and Ij arah Muntahiah Bit Tamlik
Guideline3. Murabahah and MPO Cont ract Guideline
principles, provisions of the Islamic
Banking Act 1983 and Bank Negara
Malaysias rules and regulations.
. u ara a nanc ng ont ract u e ne
5. Musharakah (financing) Contract Guideline
6. Handling and Report ing of Shariah Non
Com liances Guideline
7. Mudharabah (Deposit) Contract Guideline
8. Musharakah Mutanaqisah Contract Guideline
9. Dhamanah/ Kafalah Contract Guideline
10. Wakalah Contract Guideline
11. Tawarruq Contract Guideline
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Process of risk managementProcess of risk management
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Process of risk managementProcess of risk management
Awareness & Identification
Knowing what the risks/risk areas are
Assessment & Measurement Analytical ability to assess & measure risks
Mitigation & Control
Identif in & a l in a ro riate miti ations & controls of identifiedrisks/risk areas
Monitoring & Reporting
Continuous monitoring & appropriately reporting identified risks/risk areas
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EnablersEnablers
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EnablersEnablers
Tools to assess and monitor risk issues include: Key Risk Indicator (KRI)
Management Awareness and Self Assessment (MASA)
Risk Profiling
Portfolio / Exposure tracking Customer Ratings
Value at Risk (VaR)
Systems to manage risk issues Core Banking and Middle-wares
Financing Origination & Collection Systems
Treasur Middle Office s stems - QRisk, Quantum
Operational Risk Management System Administrative systems
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Managing Shariah nonManaging Shariah non--compliance riskcompliance risk
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Managing Shariah nonManaging Shariah non compliance riskcompliance r isk
Shariah Supervisory
Council
unc ona s ruc ure
Audit
CBNM
Sharia
Shariah Department
Examina
tio
mmittee
er
nalAudit
Audit
AuditU
nit
IAD
n
Ex
Shariah Complianc eRisk Mgmt
of
Shariah Com plianc e
Board RiskCommittee
Risk Working Group
INCEIF-LOFSA WORKSHOP, LABUANPage 46
Managing Shariah nonManaging Shariah non--compliance riskcompliance risk
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Managing Shariah nonManaging Shariah non compliance riskcompliance r iskFunctional structure
Funct ion Key Roles and Responsibilit ies/ Remarks
ShariahSupervisory
Structurally reports to Board, but functionally is independent of the Board and
management of the Bank.
ounc Governed by BNM GPS1
ShariahDepartment
Suppor t the SSCs funct ion on day-to-day basis Providing Shariahadvice based on the decisions ofShariahcouncils
on uc ng ra n ng on ar a re a e ma ers.
SCRMDepartment
Third layer of cont rol mechanism after SSC and SD.
Facilitating the process of managing SCR in the Bank.
Performing independent evaluation on products, manual & guidelines
Monitoring SNC and keeping track of income arising from SNC
Identifying internal control weakness and recommending mechanism to address
the SNC.
ShariahCompliance
Sub-committee of Management Risk Control Committee established to beresponsible for developing the SCRM capability of the Bank.
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Group
a rman: , epu y a rman: , ecre ary: ea o an
members: Senior officers from Business and Support Units.
Managing Shariah nonManaging Shariah non--compliance riskcompliance risk
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Managing Shariah nonManaging Shariah non compliance riskcompliance r isk
wareness en ca on Conduct Shariah awareness program to all staff
Incorporate Shariah requirement in operational manuals
Newsletter on quarterly basis
Risk portal
Assessment & Measurement Develop Shariah compliance risk scorecard
Shariah assessment on new products, initiatives, manuals
Mitigation & Control
Issue policy and guidelines Establish Shariah Compliance Risk Working Group
Shariah representative in all committees
Require sign off
Monitoring & Reporting Shariah non-compliances tracking report Key Risk Indicators
Monthl re ortin to MRCC and BRC
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. Objectives of the parameter:
To promote better understanding of Shariah compliance.
Shariah non-compliance is ZERO TOLERANCE
To provide a benchmark in determining the level of SNC.
RATING DEFINITION DESCRIPTION
1 Very Satisfactory No potential SNC case being reported to.
2 Satisfactory Detection of 5 cases of PSNC.
3 Fair Detection of 6 - 10 cases of PSNC.
4 Unsatisfactory Detection of > 10 cases of PSNC.
5 Very Confirmation of at least 1 SNC by SSC.
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Unsatisfactory
Shariah compliant is crucialShariah compliant is crucial
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Shariah compliant is crucialShariah compliant is crucial
Original basis for having a banking system that meets the religiousrequirements of Muslim in line with their Aqidah.
actor t at st ngu s es s am c an ng rom convent ona an ng.
Ensures acceptance, validity and enforceability of contracts from Shariah
.
Fulfills the objectives of Islamic finance i.e. to achieve justice ( adalah)
.
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Thank You
Wassalam
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