Corporate governance and risk management in islamic banks

CORPORATE GOVERNANCE AND RISK MANAGEMENT IN ISLAMIC BANKS

RISK ANALYSIS FRAMEWORK

goal of financial management is to maximize the value of a bank, as defined by its profitability and risk level.

In practical terms, the key aspect of financial management is risk management, which covers strategic and capital planning, asset-liability management, and the management of a bank’s business and financial risks.


The central components of risk management are the identification, quantification, and monitoring of the risk profile, including both banking and financial risks.

Financial risk is the a form of risk to which the banks are exposed due to their financial transactions for instance if a bank is engaged in for currency transactions than it is exposed to the fluctuations in the foreign currency rates.


Operational risks are related to a bank’s organization and functioning, including computer-related and other technologies, compliance with bank policies and procedures, and measures against mismanagement and fraud.

Business risks are associated with a bank’s business environment, including macroeconomic and policy concerns, legal and regulatory factors, and the financial sector’s infrastructure, such as payment systems and auditing professions.


exogenous risks that, if they were to materialize, could jeopardize a bank’s operations or undermine its financial condition and capital adequacy.


THE KEY COMPONENTS OF EFFECTIVE RISK MANAGEMENT

An established line function at the highest level of the bank’s management hierarchy

An established, explicit, and clear risk management strategy and a related set of policies with corresponding operational targets

Introduction of an appropriate degree of formalization and coordination of strategic decision making in relation to the risk management process.

Implementation of a process that bases business and portfolio decisions on rigorous quantitative and qualitative analyses within applicable risk parameters.

Systematic gathering of complete, timely, and consistent data relevant for risk management


Development of quantitative modeling tools to enable the simulation and analysis of the effects of changes in economic, business, and market environments on a bank’s risk profile and their impact on the bank’s liquidity, profitability, and net worth.


Risk rises exponentially with a pace of change however bank’s management is slow in adjusting to those changes and risk situations.

UNDERSTANDING THE RISK ENVIRONMENT

Changing banking environment Market oriented environment Competition by foreign banks Private sector led economic growth An external evaluation is performed for

assessing the capacity of the bank to operate successfully in the market


The assessment is performed by the supervisory authorities such as external auditors and supervisory authorities

Supervisory authorities assess whether the bank is viable, meets its regulatory requirements, and is capable of fulfilling its financial commitments to depositors and other creditors. They also verify whether or not the bank’s operations are likely to jeopardize the safety of the banking system as a whole.


External auditors assess whether financial statements provide a true and fair view of the bank’s actual condition.

The financial viability and institutional weaknesses of a bank are also evaluated through financial assessments, extended portfolio reviews, or limited assurance reviews.

THE APPRAISAL

The appraisal comprises off- and on-site examinations to the extent considered necessary.

The appraisal comprises off- and on-site examinations to the extent considered necessary.

In the case of Islamic banks, added attention must be paid to the contractual role (see table 5.2) of the bank concerned, when analyzing the risks inherent in the bank’s assets and liabilities.

ANALYSIS OF THE OVERALL BANKING SECTOR

The banking sector as a whole provides important information regarding the provision of finance to the real sector.

Sectoral analysis is important because it allows norms to be established for either the sector as a whole or for a peer group within the sector.

The performance of individual banking institutions can then be evaluated on the basis of these

norms. Deviations from expected trends and relationships may

be analyzed further, as they may disclose not only the risk faced by individual banks but also changes in the financial environment of the banking sector as a whole.

ANALYSIS OF THE OVERALL BANKING SECTOR

The banking sector analysis is also important to the policy makers

Reviews of banks can serve as a structured mechanism to ensure that monetary authorities recognize and quantify nonintermediated funding and lending as well as other processes that are important to policy makers in the central bank.

Taking a structured approach to evaluating banks makes sector statistics readily available for macroeconomic monetary analysis, which helps bank supervisors to assist monetary authorities in a meaningful way.

UNDERSTANDING BANKING RISK

Understanding banking risk in a competitive and volatile market environment is therefore a complex process

Adequate financial sector infrastructure, effective market discipline, and sufficient banking sector safety nets are crucial.

In short, to do the job well, analysts must have a holistic perspective of the financial system even when considering a specific bank.

FINANCIAL ANALYSIS

Financial analysis assesses a company’s performance and trends in that performance.

In essence, analysts convert data into financial metrics that

assist in decision making, seeking to answer various questions:

How successfully has the company performed, relative to its own past performance and relative to its competitors? How is the company likely to perform in the future?

Based on expectations about future performance, what is the value of this company or the securities it issues?

FINANCIAL ANALYSIS

Primary sources of data for financial analysis includes, the company’s projections, the company’s previous financial statements, industry structure and outlook, and macroeconomic forecasts.

Adjustments of a company’s financial statements are sometimes necessary, for example when comparing companies that use different accounting methods or assessing the impact of differences in key estimates.

FINANCIAL ANALYSIS

A number of business activities give rise to obligations that, although they are economic liabilities of a company, are not required to be reported on a company’s balance sheet.

Including such off-balance-sheet obligations in a company’s liabilities can affect ratios and conclusions based on such ratios.

RISK BASED ANALYSIS OF BANKS

Islamic and conventional banks tend to have same risk analysis framework as they are exposed to similar forms of risk

Traditional banking analysis is based on a range of quantitative supervisory tools for assessing a bank’s condition, including ratios.

The central technique for analyzing financial risk is the detailed review of a bank’s balance sheet.

Risk-based bank analysis includes important qualitative factors and places financial ratios within a broad framework of risk assessment and management and the changes or trends in risks.

Also focuses on the bank’s corporate governance practices, management and completeness of policies


Where appropriate, a bank should be analyzed as both a single entity and on a consolidated basis, taking into account exposures of subsidiaries and other related enterprises at home and abroad.

A risk-based analysis should also indicate whether an individual institution’s behavior is in line with peer group trends and industry norms, particularly when it comes to significant issues such as profitability, structure of the balance sheet, and capital adequacy.

For this reason, the issue of usefulness and transparency is critical, as is accountability.


Financial analysis is the discipline whereby analytical tools are applied to financial statements and other financial data, in order to interpret trends and relationships in a consistent and disciplined manner.

The objective of financial statements prepared according to IFRS and Generally Accepted Accounting Principles (GAAP) is to provide information that is useful in making economic decisions.

The financial analyst must be capable of using the financial statements in conjunction with other information in order to reach valid investment conclusions.


Integrating the various analytical components and techniques discussed in this chapter will distinguish a well-reasoned analysis from a mere compilation of various pieces of information, computations, tables, and graphs. The challenge is for the analyst to develop a storyline, providing context (country, macroeconomy, sector, accounting, auditing, and industry regulation, as well as any material limitations on the entity being analyzed),

a description of corporate governance, and financial and operational risk and then relating the different areas of analysis by identifying how issues affect one another.


Before starting, the analyst should attempt to answer at least the following questions: What is the purpose of the analysis? What level of detail will be needed? What factors or relationships (context) will influence

the analysis? What are the analytical limitations, and will these

limitations have the potential to impair the analysis? What data are available? How will data be processed? What methodologies will be used to interpret the

data? How will conclusions and recommendations be

communicated?

RISK BASED ANALYSIS OF BANKS Once the analyst is sure that the overall approach

and reasoning are sound, the analytic review should focus on the following issues: What happened, established through computation or

questionnaires; Why it happened, established through analysis; The impact of the event or trend, established through

interpretation of analysis; The response and strategy of management, established

through evaluation of the quality of corporate governance;

The recommendations of the analyst, established through interpretation and forecasting of results of the analysis;

The vulnerabilities that should be highlighted, included in the recommendations of the analyst.


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Corporate governance and risk management in islamic banks