Risk Assessment on Islamic Financial Institutions - Research Proposal Example

Risk assessment on Islamic Financial Institutions Name ID Number Lecturer’s Name Date Introduction This study is being conducted to increase academic knowledge and also help in giving a better understanding on Risk Management in Islamic Financial Institutions. It will also work towards improving risk management practices in Islamic Financial Institutions. It will also explore the issue of corporate risk assessment and management in the perspective of Islamic Financial Institutions, ran on the Islamic legal and financial structure, which forbids Riba (interest), shuns Gharar (uncertainty), and avoids Maysir (gambling or excessive speculation) (Iqbal 36). This essay will concentrate on the relevancy of the research, data collection, analysis and findings. Background Islamic finance includes Capital Markets, Banking and Insurance business and has emerged as an incredibly imperative part of finance that plays an immense role in the financial market. The scope of the Islamic institutions has significantly grown in terms of customers it serves, products offered, and funding of such institutions has also increased (Askari 7). The institutions operating have increased and are operating with different intensity. The institutions include both pure Islamic institutions and hybrid players. The hybrid institutions are those conventional banks that operate with Islamic finance rules. Therefore, it of immense importance to understanding the risks that can be faced the Islamic Finance institutions. The Islamic finance has two models, risk sharing and risk pooling that acts as a guide during financial operations. Failure of the two models would result to a financial crisis and would also have an effect on the Islamic faith (Iqbal and Ariff 86). Therefore, it is essential to manage the risks so as to avoid a financial crisis. There are more than 200 Islamic financial institutions that are in operation, in 48 countries, and their assets when combined, are more than $ 200 billion (Askari 12). They have an annual growth rate of between 12 and 15%. This rapid mushrooming of Islamic financial institutions (IFI) had fascinated a lot of interest between the financial circles, and as a result, a range of market participants have recognized the potential in them. Research has shown that Islamic banking is expected to attract 40% to 50% of Muslim population total savings, across the world in the coming not many years. After taking advantage of the potential market, many financial institutions like Goldman Sachs, Citibank, UBS and BNP-Paris-Bas, have convened Islamic banking and established Islamic Shariah well-matched services in a number of countries (Greuning and Iqbal 4). This opportunity growth, as well as, challenges that face the development of Islamic financial institutions in the world market, has illuminated issues of public policy in the category in which they internationally operate. These factors have made international standard setters, international organizations, national regulatory authorities, academia as well as policy makers to scrutinize assorted factors and characteristics of Islamic financial intermediation, all from their own point of view (Greuning and Iqbal 2). As a result of the Islamic financial institutions growth and the attention it is attracting, focus is being aimed at IFI’s management of risks practices, the wide and diverse institutional arena they work operate from, as well as the regulatory structure that govern them. Various institutions have been put into place, to be central points, governing key issues like the accounting and auditing organization for Islamic financial institutions (AAOIFI) and the liquidity management centre (LMC) (Ariff and Iqbal 125). Although the swift and hasty expansion and growth of Islamic financial institution has created hopes and expectations, there is also apprehension on risks that may come along with the rapid expansion. This is because financial innovation and expansion always pave way for risks as it changes. Change and growth of any sector in the society brings on board some risks because, change and growth involves venturing into new environments, and it takes time to get acquainted. The same case applies to Islamic institutions, as they are not immune to change and growth. As a result, Islamic finance emergence to the global financial landscape brings on the ground challenges same to those belonging to financial innovation (Askari 26). This has raised concerns on the possible risks it can cause, and their impact on other financial system because it is not well understood as compared to conventional finance. Islamic finance institution over the years has been rated as the fastest emergent sector, and it has developed way beyond, its conventional markets, to being a world phenomenon. Relevance of the project Aims and objectives This research looks forward to investigate the operations of Islamic financial institutions and assess the possible risks, since the Islamic financial institution is rated as the global fastest growing and expanding section of the financial sector. Islamic finance has already broken its banks and confines in the Middle East and Muslim countries, and has ventured into the outside world like Dubai and Kuala Lumpur, vying with London to be the principal Islamic finance. A lot of study have been done and written on Islamic finance as well as risk assessment, but little has been done of Islamic financial institutions risk assessment. This projects aim at showing that Islamic finance is in no way riskier than the conventional finance, instead, that it is just different. Objectives General objective The general intention of this research study is to look at and review the probability of risks curbing the expansion of the Islamic finance, and if these risks are different from those faced by the conventional finance. The specific objectives of this study are: To study Islamic financial institutions and find out the risks it poses as a result of its nature and principles. To understand the difference between the risks faced by Islamic financial institutions and those of conventional finance. To examine how the present risks are being addressed. To assess how these practices can be developed. Research questions The research questions will help the researcher to achieve the objectives of this study, and they are the following: i. What are the risks that the Islamic financial institutions face due to its unique nature and principles? ii. Are there differences between the risks faced by the Islamic financial institution and those of conventional finance? iii. What are the risks that are likely to be faced by Islamic financial institutions? iv. How are the present risks being addressed? Literature review This research looks forward at finding out about the risks that face, or are bound to be faced by, the Islamic financial institutions, and how to mitigate these risks as well as prevent them from causing losses. The major global concern is how governments and Islamic financial institution will respond and counter the challenges and risks that loom on the horizon and future (Askari 23). The future achievement of Islamic Finance will be resolved by a couple of developments like financial and economic reforms in Islamic regions and countries, economic growth pace, research into Shariah compatible products development, as well as governance of IFI. Sharia law covers more than finance as it interprets ethical codes for all aspects ranging from prayers, to economics and prayers (Ariff and Iqbal 9). According to the Islamic law, interest taking is prohibited, while ownership and trading are expected to be done in transparency. Since all things are believed to belong to God, inequities in risks are forbidden, also are limits on insurance and personal liability. All this poses the quagmire for investors and developers who are keen on seeking out and profit from chances in the surfacing markets, and these includes even the Muslim investors (Ariff and Iqbal 36). The strict Sharia laws provide the downside for the Islamic vehicles (Iqbal and Greuning 93). Sharia limits investment opportunities numbers. This, in turn, drags performance, and in the long run, the capital markets of countries like Lebanon, have sunk overall valuations in the past months. The world suffered a great depression in 2007 because, the most refined risk management techniques and strategies in the financial industry globally, failed in a catastrophic manner. The catastrophic crash in risk management finance computation among the leading financial institutions in the world demonstrates the necessity for a more interdisciplinary, holistic and wide enterprise risk management approach. This risk management approach should incorporate mathematics, accounting, economics, technology and operations (Tarantino and Cernauskas 8). The failure also exhibits the need for the right tone at the- top, where ethical considerations and reflection are heavily weighed as restricted business considerations in opportunity decisions or risks. To avoid a repeat of painful risk management and ethics failure, research, has been done and is being done, so as to counter the possible risks. It is important for the contemporary business, accounting, audit, finance, IT and nonprofit managers to embrace risk management, as everybody’s job and responsibility (Askari 157). The complexity of marketplace risk management techniques, as well as, financial products should be understood as risks. Global financial crisis or recessions have on board all types of risk, which combines to investors, overwhelming regulators as well as corporate governance (Tarantino and Cernauska 5). Risk assessment is an assessment process that deal with fears and uncertainties, and to curb these uncertainties and transform them to increase the entity value. The aspect of risk and the uncertainty risk is the probability of a gain or even a loss. One side is riskier than the other, if there is the presence of a greater uncertainty or the expected loss is greater. This project aims at assessing the risks faced by the IFI which include legal risks, credit risk, profit rate risk, reputational risk, liquidity risk, market risk, as well as operational risk. IFR face a special type of risk called faith- based risk (Tarantino and Cernauskas 234), which comprises the most dangerous risks that are faced by enterprises. Methodology and design So as, to achieve the purpose and objectives of this study, the research methodology will involve both quantitative and qualitative techniques. Questioners on risk assessment practices in the Islamic financial institutions will be asked to professionals and advisors working with Islamic financial institutions, on Linkedin. These questions will focus on factors like risk assessment models; how risk assessment is carried out, and how they are dealt with, according to their own opinions. The questioner will play a big role in giving an insight of current and modern practices in risk assessment and trigger opinion about the way forward. Data collection Data collection was based on the research questions generated. The following questions were asked to professional advisors working in Islamic Financial institutions (IFI), based on the research objectives, and they were asked on LinkedIn: 1. How do you identify the probability of a risk occurring, in the Islamic financial institutions? This question was aimed at finding out how possible risks and uncertainties are identified so that they can be assessed. 2. Is the quantification of risks done in accordance with their occurrence frequency? This question was asked to help in the analysis of implications, and to determine the most likely risks to occur. 3. Among the following responses to minimize risks, indicate the frequency that each is chosen. a) Risk avoidance b) Risk reduction c) Risk transfer d) Risk retention. 4. From your point of analysis, do you think the state of risk assessment practices is enough for Islamic financial institution needs? The research was done on three Islamic financial institutions which are; Al Barak banking group (based in Bahrain, North Africa regions and Middle East), Meezan Bank (Pakistan) and Khaleej Takaful- Insurance (Based in Dubai). This research is limited only to members who belong to Linkedin groups, and who are interested in Islamic finance. It is also limited to the public information on Annual financial Statement of the selected financial institutions. Therefore, this study will not contain detailed information on risk assessment of the selected Islamic institutions. The views about the way forward will be only limited to the opinions of the questioner respondents. Analysis and findings Basing on the questions asked to respondents on linkedin, analysis was done and findings deduced on public information received for Meezan Bank, Khaleej Takaful- insurance and Al Barak banking group. Analysis will be done for the pilot survey done on groups related to Islamic finance. These groups are; Halal research council, Islamic banker, Islamic banking professionals, Islamic banking and finance, Islamic finance consultants, Islamic finance research, Advisors and practitioners, and Islamic finance research. Members of these groups were requested to answer the questioner and give their personal opinions. This survey was done using Zoomerang. The response got was not encouraging, and this is attributed to the factor that there was fear of revealing confidential information, and not because there was covering up of frail risk assessment practices among the Islamic financial institutions. Out of 86 visits to the page, only 23 people responded. The response to the questions was as follows. Question 1: How do you identify the probability of a risk occurring, in the Islamic financial institutions? Table 1 Identifying probability Frequency Percentage none 3 13 Specialized risk assessment department 12 52 Incidents reports 8 35 Total 23 100 Author (2012) Chart 1 Author (2012) On how to determine the probability of a risk occurring, there 23 respondents who responded gave various answers. 13% of the respondents argued that there are no methods used to determine the probability of a risk occurring in Islamic financial institutions. In this case, the respondents either do not know how risks occurrence is identified, or they believe that there no way to identify a potential risk that might face or have ever faced Islamic financial institutions. 52% of the respondents responded that there are specialized risk assessment departments that are charged with identifying possible occurrence of risks in Islamic financial institutions. 35% of the respondents argued that risk occurrence can be identified from the events reported that trigger or point towards a risk occurring. Question 2: Is the quantification of risks done in accordance with their occurrence frequency? Table 2 Quantification of risks according to frequency Frequency Percentage Yes 18 78 No 5 22 Total 23 100 Author (2012) Chart 2 Author (2012) The respondents were asked if they think risk are quantified in accordance with the amount of times they take place. 78% of the 23 respondents argued that risks are quantified and later assessed according to the number of times they occur. 22% of the respondents were of the belief that risks are not quantified according to how many times they occur. In the Islamic financial institutions risks that occur many times are assessed first and are given the first priority in terms of risk management, while those that do not occur many times are considered to be lesser risks. Question 3: Among the following responses to minimize risks, indicate the frequency that each is chosen. Table 3 Responses to minimize risks Frequency Percentage Risk Avoidance 10 43 Risk retention 6 26 Risk transfer 3 14 Risk reduction 4 17 Total 23 100 Author (2012) Chart 3 Author (2012) Respondents in Islamic financial institutions questioned about the responses to minimize risks and how often they are used, they responded in the following ways. 43% of the 23 respondents who answered the questions were of the opinion that Islamic financial institutions use risk avoidance as a response to minimize possible risks. 26% of the respondents were of the view that Islamic financial institutions use risk retention as a means of minimizing and reducing risks. 14% of the respondents, who answered about the measures taken, by the Islamic financial institutions to reduce risks, were of the opinion that risk transfer is the measure put in place to reduce risks. 17% of the respondents were of the opinion that the Islamic financial Institutions apply risk reduction as a means of reducing the risks facing the financial institution. Question 4: From your point of view, do you think the state of risk assessment practices is enough for Islamic financial institution needs? Table 1 Enough risk assessment practices Frequency Percentage Yes 2 9 No 21 91 Total 23 100 Author (2012) Chart 4 Author (2012) The respondents were asked whether they think that the state of risk assessment practices done is enough for the needs of Islamic financial institution, and the responses were as following. 9 percent of the 23 respondents are the only ones who believed that the risk assessment practices are enough for the needs of Islamic financial institutions, while 91% of the respondents were of the view that, the Islamic financial institution needs more risk assessment practices for their needs. Recommendations This study illuminates the fact that there is no social responsibility of people involved with the Islamic financial institutions (Tarantino and Cernauskas 78). This is because, as much as the study was aimed at assessing the risks in the Islamic financial institution, the people benefiting from it were not willing to offer information. Research studies are done in order to dig up at the origin of the problem and provide solutions. In this case, the risk assessment was to discover the risk involved and learn how to manage them. Therefore, people are supposed to have ownership of their environment and have a social responsibility so as to tackle the risks as they come. According to Sharia, Islamic banking is based on the principles of sharing loss and profit. It also prohibits paying and collecting interest (Iqbal and Ariff 96). Therefore, the collective sharing of profits and losses should be exhibited when preventing risks, as well as managing them. Risk pooling should be the best measure taken to manage risks in the Islamic financial institutions. This is according to the Takaful- Islamic insurance, which requires members to give in money into a system of pooling (Iqbal and Greuning 76). This pooling system guarantees each person against damage, or even loss. This enables social, economic, and financial responsibility, aimed at shielding each other. Since the Islamic law prohibits collection of interest, the Islamic bond called Sukuk should come in to link financing cash flows and returns to the returns of purchased assets (Askari 112). The reason for this is for the Islamic financial institutions to avoid trading in debt, which is prohibited by the Islamic law. Therefore, financing is only required to be raised for assets that are identified. Work Cited Askari, Hossein. New Issues In Islamic Finance and Economics: Progress and Challenges. John Wiley & Sons, 2008. Print. Tarantino, A and Deborah Cernauskas. Essentials of Risk Management in Finance. New Jersey: John Wiley and Sons, 2011. Print. Iqbal, Zamir and Hennie Greuning. Ed. Risk Analysis for Islamic Banks. London: World bank, 2007. Print. qbal, Zamir. Risk and Risk Management In Islamic Finance, Paper Presented to the Conference on Islamic Financial Services Industry in the 21st Century, Alexandria University, October 2000. Web. 5 Nov 2012. Ariff, Mohamed and Munawar Iqbal. The Foundation of Islamic Banking: Theory, Practice and Education. Massachusetts: Edward Elgar publishing Ltd, 2011. Print. Read More