Risk Management for Islamic Banks. Imam Wahyudi

set by the bank's owners. If the bank is able to manage risk appropriately, then not only will the bank avoid the more obvious risks, but the Islamic bank can also change that risk into a business opportunity that can generate profit for the bank.

      The rapid development of Islamic banks has been followed by other Islamic financial institutions, such as Islamic insurance, Islamic leasing companies, Islamic venture capital, Islamic capital market, Islamic money market, Islamic microfinance institutions, and the like. These institutions often interact with one another, both directly and indirectly. Interconnection occurs through financial institutions between them, both on the asset side (financing or fund placement in other institutions); while indirect interconnection occurs through indirect investment activities (or issuing securities) in the financial market. Other than the interconnection between financial institutions, the product and operating activities of the Islamic bank are also developing into more complex and sophisticated forms, making it necessary to develop risk management and analysis that is also more comprehensive.

      Like the sides of a coin, the rate-of-return and risk will always be attached to each other in a business. Islam admits the presence of profit the same way it admits the presence of risk. In a fiqh principle, it is stated, “al ghunmu bil ghurmi” and “al kharaju bidh dhamani,” also known under the modern financial term of “risk-return trade-off.” The application of reliable risk management is just as important as the application of various business strategies to optimize rate-of-return. A bank's birth is similar to that of a baby with permanent and inconveniencing disabilities; the bank will always exist in a state of permanent mismatch liquidity, and bears the risk from it. Even if the Islamic bank is able to reduce and even eliminate its financial risks, such as default risk, market risk, operational risk, rate-of-return risk, investment risk, and various other nonfinancial risks such as reputation risk, syari'ah-compliance risk, strategic risk, and other business risk, the Islamic bank will still face liquidity risk. This means that the bank's failure in managing various risks, other than liquidity risk, will worsen the bank's already-present “flaw.” Under extreme conditions, the bank will be paralyzed and unable to perform its role as financial intermediary.

      A well-designed risk management approach, accommodating the distinct products and operating activities of an Islamic bank and performed with utmost prudence, is the prerequisite of maintaining the existence of the Islamic bank as a highly competitive institution: prudent, profitable and able to generate loyalty in its customers. Apart from that, a well-managed risk will also ease the regulator in performing its duties in monitoring the Islamic bank's risks and ensuring the banking industry's health, both on a micro as well as macro level. This is in line with the authority of regulators in every country related to the supervision and management of the banking industry and ensures that prudential principles are followed in a bank's business activities. These activities include risk management, bank governance, and the principle of knowing your customer; prevention against money-laundering and terrorism and criminal enterprise financing; and bank checks. The application of comprehensive risk management in the Islamic bank is expected to be able to protect the banking industry and depositors from various possible aberrations that can occur, as well as mismanagement.

      The coverage of risk is very wide and is as extensive as the business process run by the bank itself. In principle, risk is attached to every business activity. To understand the framework of risk management comprehensively and holistically, the Islamic bank's business processes will first need to be understood in detail: the innovation process and development of banking products, the creation of contracts and their different maturities, the methods the bank uses to place itself in the customer's perspective as well as its stakeholders, and so on. Various questions on the bank's existence and survival need to be asked and answered to build a reliable risk management system for the bank. Related to that issue, various existing literature tend to choose one of two approaches: The first approach explains the risk management framework from the approach of risk measurement. In the first approach, each risk has a distinct characteristic, philosophy, and trait. For that, we often find one book that specializes in discussing various methodologies, methods, and market risk measurements. Other books specialize in discussing the measurement of credit risk, while yet others cover operating risk and the like. The second approach is the book or literature that discusses how risk management is built in part as a system, as in the application of enterprise risk management (ERM). In this book, it usually explains how a bank or another institution integrates risk management into the entire element of the business unit. Risk management is not treated as a separate business function, but is integrated with vision, mission, planning, and performance measurement. Whether the bank's goals are achieved or not is not only determined by the fulfilment of the bank's return target, but also by the risk measure applied.

      The two approaches require a basic understanding of an Islamic bank's business process and also of the characteristic, philosophy, and distinct trait of each risk faced. Up until now, we have yet to encounter a single book or literature that tries to clearly explain the two prerequisites. As such, we endeavor to analyze various business processes present in Islamic banking. We try to identify the existence of risk and its type, as well as understand the characteristics, philosophy, and distinct character of each risk. All these we have tried to write in this book. This book does not begin from a case study of any particular Islamic bank, but discusses the common traits of Islamic banking around the world. The approach that we use is a combination of regulation analysis, literature study and analysis of field practices on several Islamic banking institutions. Various findings and analyses of field practice are used as a basis to draw general conclusions on the character and practice of the Islamic banking industry.

      This book consists of five parts. Part I is the introduction and consists of two chapters: Chapter 1 discusses the basic philosophy of the Islamic financial system, including the banks. Specifically, this chapter will discuss the characteristics of Islamic finance and the concept of usury that is prohibited in Islam. Chapter 2 will explain Islamic banks and risk management, various global institutions related with an Islamic bank's activities (e.g., the Islamic Financial Services Board [IFSB], the Basel Committee on Banking Supervision [BCBS], and the Accounting and Auditing Organization for Islamic Financial Institutions [AAOIFI]), as well as best practices of bank governance. The chapter also discusses the philosophy of risk management, especially related to the meaning and concept of risk, the understanding that risk is inseparable from the Islamic bank, the stages of risk management practices, the relevance of risk and rate-of-return, Islamic perspective on risk, risks faced by the Islamic bank, various approaches to recognizing risk and the benefits that can be reaped by the Islamic bank from good risk management.

       Part II discusses the risk management framework in the Islamic bank. This part consists of three chapters: Chapter 3 discusses the history of risk management development in Islamic banks. It begins by discussing why the bank will need to be managed and supervised, why various regulations emerged, and why it is necessary to create an agreement on operating ground rules in the global financial system, then continues with discussions of Basel I, Basel II, and Basel III. The framework and coverage of these three frameworks are discussed to understand the reason for various amendments and revisions. Then, Chapter 3 specifically discusses Islamic bank accounting standards. This discussion is important considering various measurements, methods, and risk models are based on accounting systems and reporting. The end of Chapter 3 discusses the risk management framework in the IFSB as a community of global Islamic financial institutions, and various regulations that are specifically issued by Bank Indonesia as Indonesia's banking regulator. In Chapter 4, this book discusses the risk management process in an Islamic bank. Specifically, the chapter explains the philosophy that risk management is a continuous process, then enters the topic of risk management models in an Islamic bank along with the risk identification process, the development of the risk matrix, the risk mitigation process, and the risk review process. The final part of Chapter 4 will discuss various