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Essay: Risk Management Framework of Islamic Financial System

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  • Published: 2 October 2015*
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  • Words: 1,272 (approx)
  • Number of pages: 6 (approx)

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A’Long Term Objective of Develop Islamic Financial System
1. Improve legal framework and develop shariah governance
2. Diversify islamic capital market
3. Broden Islamic financial intermediation.
B. Long Term Plan of Develop Islamic Financial System
Develop Real-estate Finance
Islamic banks are heavily involved in all aspects of real-estate financing, from residential mortgages to the finance of major commercial property developments through istisna (project finance). In addition to mortgages for owner-occupied properties there is much buy-to-let activity and therefore the large expatriate workforce offers a captive market for landlords. Housing finance is also a major Islamic financing activity.
Develop Islamic Investment Banking
Investment banking is arguably more compatible with shariah than is retail banking, since much of its income is fee-based rather than accruing from lending and charging interest. Musharaka partnership is an appropriate structure for syndications, as it involves profit and loss sharing, with profits shared in accordance with contractually agreed ratios between the partners and losses shared in proportion to the subscribed capital . The provisions are clear and there is no problem in drawing up legal contracts consistent with shariah principles for this type of financing facility.
Sukuk Issuance
There has been particular concern over musharaka and mudaraba sukuk, as these contracts are supposed to involve risk sharing without capital guarantees to the investors to justify the profits earned.
Develop Takaful Industries
In shariah conventional insurance is prohibited, as it involves the transfer rather than the sharing of risk, the moral teaching in Islam stressing the sharing of each other’s burdens. There are also objections to the uncertainties and ambiguity (gharar) in many insurance contracts, where once claims are made the company tries to minimize or refuses to pay compensation by referring to minor clauses in the contract that the policyholder may have misunderstood. More fundamentally, there is the issue of paying a premium for an uncertain benefit, and whether this constitutes gharar. With takaful the client makes a donation (tabarru) for mutual benefit rather than paying a premium for a personal benefit. Hence gharar is less likely, as probability theory suggests that where there are large numbers of participants in a scheme, some will almost certainly benefit. A further objection to conventional insurance is that most companies hold a significant portion of their assets in interest-yielding securities. In contrast, takaful operators invest in sukuk, which pay profits or rent rather than interest
Develop Sharish-compliant Cnsumer Credit
Islamic consumer credit also covers car purchases and home equipment and improvements such as new bathrooms, kitchens or furnishings. Car finance involves murabaha, the bank purchasing a car on behalf of the client and reselling to the client for deferred payments
Develop Islamic Mutual Funds
Develop Islamic Bank Deposit Facilities
Members contribute small amounts of savings in return for being potentially eligible for modest interest-free loans, referred to as qard hasan in Islamic financial parlance (Warde 2000). Those who joined were relatively poor farmers, comparable to the clientele of microfinance institutions, who are too poor to have bank accounts and are without collateral to offer for loans.
Develop Trade Finance Using Murabah
The bank would buy imports on behalf of a merchant and resell them to the merchant for a mark-up. It was the mark-up rather than interest that represented the bank’s profit, but what made the transaction shariah compliant was the fact that the bank assumed temporary ownership of the imports; the legal responsibilities associated with this justified the returns.
C. Risk Management
Shariah Governance Framework: The Framework is designed to meet the objectives of outlining expectations on an IFI’s Shariah governance structures, processes and arrangements, and providing comprehensive guidance to the key functions in discharging its duties relating to Shariah, in order to ensure that all its operations and business activities are in accordance with Shariah principles.
Risk Governance: The policy document on Risk Governance describes the supervisory expectations on risk governance practices in financial institutions
‘ Roles of the board and senior management oversight.
‘ Independence of risk management and control functions.
‘ Importance of having a holistic view of all relevant risks
‘ Ensuring that reporting of risks provides an integrated view which points to an ERM type approach
Islamic financial institutions faced unique risks. Given that there was no well-defined risk management framework for Islamic financial institutions, they mostly tended to deal with the risks they faced in accordance with conventional guidelines. It was, however, important that risk managers identified the risks faced by Islamic financial institutions correctly, measured them accordingly, mitigated and controlled them in accordance with Shari’a requirements and reported them to all the stakeholders honestly and accurately.
In additional to the above, financial institutions employed standard static and dynamic tools for the valuation of market risk. The Value at Risk (VaR) modelling technique was typically used as a measurement indicator for market risk. It measured a financial institutions’s aggregate market risk exposure if it were to hold specific assets for a certain period of time. Inputs to this model included data on the financial institutions’s position (book value, market value), prices, volatility and risk factors. The VaR model had to be supported by various tests in order to ensure robustness and effectiveness of the results. Back testing was applied to check whether VaR predictions corresponded to observed market changes. Stress testing assessed the consequence of risks that might have appeared in extreme circumstances.
Effective risk management requires a reporting and review structure to ensure that risks are effectively identified and assessed and that appropriate controls and responses are in place (IRM, AIRMIC and ALARM; 2002). Risk monitoring can be used to make sure that risk management practices are in line and proper risk monitoring also helps bank management to discover mistake at early stage (Al-Tamimi and Al-Mazrooei, 2007). Monitoring is the last step in the corporate risk management process (Pausenberger and Nassauer, 2002).
According to them, control has to be established at different levels. The control by the management board will not be enough to ensure the effective functioning of the risk monitoring system, because the management board members do not have time on their hands to exercise extensive control. Hence, the management board will install an independent unit to complete the task of internal supervision. This task is the responsibility of the internal audit.
Also, the supervisory board is obliged to control the risk management process. The supervisory board is supported by the auditor. If the auditor discovers a defect, he will have to inform the supervisory board and the management board. Finally, the shareholders of the corporation can use their rights to demand information in order to judge the efficiency of the risk management system. The director’s report enables the shareholders to assess the status of the corporation knowledgeably and thoroughly. Khan and Ahmad (2001) conducted a survey of risk management practices and found that on average the lowest percentage is on the measuring, mitigating and monitoring risk i.e. 69% score as compared to risk management policies and procedures i.e. 82.4%, and internal control of Islamic banks i.e. 76%. Al-Tamimi and Al-Mazrooei (2007) found that there is significant difference between UAE national and foreign banks in risk monitoring and controlling. Also, the UAE commercial banks have an efficient risk monitoring and controlling system and it has positive influence on risk management practices.
Finally, risk monitoring is important process to ensure that risk management effectively been practiced by financial institutions.
It is apparent from this project that development of Islamic financial system in Iraq is significant and can contribute to the development of economic and society. However, risk management is more significant. Though above contubutions, I believe that it can promote the development of islamic fiancial system in Iraq.

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