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Fund Management

Introduction
Funds management is the core of sound bank planning and financial management. It encompasses the management of the bank’s liquidity position or management of assets and liabilities to provide adequate resources to meet anticipated fund demand.

Competitive and regulatory pressures make it mandatory to have a sound company-wide risk management framework in place. Companies that do not implement such a risk management framework may be unable to compete effectively in today’s marketplace.

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A global marketplace characterized by the commoditization of customer driven business, industry consolidation, deregulation, service line expansion and technology advances has heightened the level and nature of potential risks. The current environment demands sophisticated and comprehensive controls to quickly bring products to market, reduce operating costs, and most important, maintain risk within acceptable balances. The expectations of Boards of Directors, regulatory bodies, rating agencies, and shareholders regarding controls continue to rise. Moreover, it goes beyond just “risk controls”; market leaders have evolved “risk management” to the point where they view it as a core competency.

As a core competency, risk management empowers organizations to not only control risk, but also measure performance more effectively, determine capital allocations and realize a variety of other business advantages. Thus, by being more proactive, an organization can gain a competitive edge and even enhance its business reputation.

Evolution of Risk Management Practices
During the late 1980s and early 1990s, as financial markets and products became increasingly sophisticated and complex, risk management developed into a highly specialized area of expertise. Over the past decade, many institutions have invested heavily in the development of systems to better measure and manage specific risks. However, in recent years, there have been developing trends in the market environment creating the need for institutions to manage risk more comprehensively because of the evolution of existing products and emergence of Islamic products.

While institutions continue to strengthen risk management practices in specific areas, a less than comprehensive approach has led to significant losses at certain institutions.

Risk Dimensions
Risk dimensions include such risks as market, credit, settlement, operational, liquidity, and legal/compliance and will vary in importance based on the business activities of an organization.

Risk Management Life Cycle
The risk management life cycle includes the four phases of identification, measurement, management, and monitoring.

Organizational Responsibilities
Risk management needs to be performed on a company-wide basis involving the Board of Directors, credit, senior management, independent risk management, business line management, finance and control, legal/compliance, treasury and operations, with significant support from internal audit and information technology, incase of Islamic banks Shariah Advisory Board.

Business Processes
Risks are rooted in every step of an organization’s business processing flow from the establishment of business strategy and policies and procedures through the evaluation and control of individual transactions.

These fundamental risk management perspectives should be used as the basis of any review and assessment of an organization’s risk management policies and practices.

Evolution
The banking industry in developed markets is undergoing a steady and profound transformation. The areas in which banks have historically generated most of their profits are being squeezed, eliminated by technology and appropriated by new players. To compensate, banks are pursuing growth in sectors, which previously fell for example Islamic Banking.

Islamic Banking
Since the early 1960s, Muslim economists have been propagating the idea of profit-loss sharing (PLS) in the banking business. The main philosophy is distributive justice. More attention is given to the asset side of the balance sheet, namely financing, while deposit mobilization receives relatively less attention.

Riba or interest, which is banned by the Quran, is considered unproductive since it is created without risk. Sometimes, Muslim economists tend to use the Marxian argument that interest and capital have no value since value is only created by labor. As such, any gain where labor is absent is illegitimate. Thus, capital without labor is impotent. Capital becomes productive only when labor is added to it. In other words, there is no production process without labor.

In the Islamic banking system today, the creation of profit in the Murabaha and Musharaka financing is considered legitimate because in trading and commerce, (Al-bay’) capital is combined with labor. Riba profit is not a legitimate form of income because it is created from “capital divorced of labor”. That is, the bank is not taking an active and meaningful role in converting capital input into final output.

But as an intermediary, a bank may find it too demanding to be directly involved in production, such as manufacturing or farming. The risks in production are too overwhelming. Banks have refused to combine their loan capital with labor out of fear that the business entity in which both capital and labor are combined will close down due to market risks.

Islamic Financial Institutions: Nature and Risks
Distinguish two models of Islamic banks based on the structure of the assets. The first is the two –tier Mudarabah model that replaces interest by profit-sharing (PS) modes on both liability and asset sides of the bank. In particular, in this model all assets are financed by PS modes of financing (Mudarabah). This model of Islamic banking will also take up the role of an investment intermediary, rather than being a commercial bank only.

The second model of Islamic banking is the one-tier Mudarabah with multiple investment tools. This model evolved because Islamic banks faced practical and operational problems in using profit-sharing modes of financing on the asset side. As mentioned earlier, fixed-income instruments include Murabaha (cost-plus or mark –up sale), installment sale (medium/ long-term Murabaha), Istisna / Salam (object deferred sale or pre-paid sale) and Ijarah.

Islamic banking offers financial services by complying with the religious prohibition of Riba. Riba is a return (interest) charged in a loan (Qard hasana) contract. This religious injunction has sharpened the differences between current accounts (interest for loans taken by owners of the Islamic bank) and investment deposits (Mudarabah funds). In the former case, the repayment on demand of the principal amount is guaranteed without any return. The owners of current accounts do not share with the bank in its risks. In case of investment deposits, neither the principal nor a return is guaranteed. Investment accounts can be further classified as restricted and unrestricted, the former having restrictions on assets that the funds can be used for and on withdrawals before maturity date. The owners of investment accounts participate in the risks and share in the bank’s profits on pro-rata basis. The contracts of Qard hasana and Mudarabah are thus the fundamental pillars of Islamic banking and their characteristics must fully be protected for the preservation of the uniqueness of Islamic banks.

The Islamic bank described above appears to have characteristics of both an investment intermediary and a commercial bank. The ownership pattern of the Islamic bank resembles that of a commercial bank as the depositors do not own the bank and do not have voting rights. In Islamic finance parlance, this means while Musharaka contract characterizes the equity; owner deposits take the form of Mudarabah contracts. An Islamic bank, however, has similarities with an investment intermediary as it shares the profit generated from its operations with those who hold investment accounts. After paying the depositors a share of the profit, the residual net-income is given out to the shareholders as dividends.

Using profit- sharing modes in Islamic banks changes the nature of risks these institutions face. The returns on saving/ investment deposit are state contingent. As the depositors are rewarded on a profit-loss sharing (PLS) method, they share the business risks of the banking operations of the bank. The profit/ loss-sharing feature of these depositors introduces some other risks. Furthermore, the use of Islamic modes of financing on the asset sides changes the nature of traditional risks. We outline the nature of risks that Islamic banks face and risks inherent in different modes of financing below.

Nature of Risks Faced by Islamic Banks
Credit Risk
Credit risk would take the form of settlement/ payment risks arising when one party to a deal pays money (e.g. in a Slam or Istisna contract) or delivers assets (e.g., in a Murabaha contract) before receiving its own assets or cash, thereby, exposing it to potential loss. In case of profit-sharing modes of financing (like Mudarabah and Musharaka) the credit risk will be non-payment of the share of the bank by the entrepreneur when it is due. This problem may arise for banks in these cases due to the asymmetric information problem in which they do not have sufficient information on the actual profit of the firm. As Murabaha contracts are trading contracts, credit risk arises in the form of counterparty risk due to nonperformance of a trading partner. The nonperformance can be due to external systematic sources.

Benchmark Risk
As Islamic banks do not deal with interest rate, it may appear that they do not have market risks arising from changes in the interest rate. Changes in the market interest rate, however, introduce some risks in the earnings of Islamic financial institutions. Financial institutions use a benchmark rate, to price different financial instruments. Specifically, in a Murabaha contract the mark-up is determined by adding the risk premium to the benchmark rate (usually the LIBOR). The nature of fixed income assets is such that the mark-up is fixed for the duration of the contract. As such if the benchmark rate changes, the mark-up rates on these fixed income contracts cannot be adjusted. As a result Islamic banks face risks arising from movements in market interest rate.

Liquidity Risk
As mentioned above, liquidity risk arises from either difficulties in obtaining cash at reasonable cost from borrowings or sale of assets. The liquidity risk arising from both sources is critical for Islamic banks. As interest based loans are prohibited by Shari’ah, Islamic banks cannot borrow funds to meet liquidity requirement in case of need. Furthermore, Shari’ah does not allow the sale of debt, other than its face value; thus, to raise funds by selling debt-based assets is not an option for Islamic financial institutions.

The general understanding is that it is due to prohibition on participation in the so-called money market, which primarily deals in fixed income securities. Islamic banks, globally, hold Islamic Bonds or Sukuk, but there is no secondary market trading in these issues. Therefore such securities are only held to maturity and therefore cannot be converted into cash. In Pakistan it is even worse because of absence/lack of such instruments. But Islamic banks with the help of State Bank of Pakistan are in the phase of developing such instruments.

Operational Risk
Given the newness of Islamic banks, operational risk in terms of person risk can be acute in these institutions. Operational risk in this respect particularly arises as the banks may not have enough qualified professionals (capacity and capability) to conduct the Islamic financial operations. Given the different nature of business the computer software available in the market for conventional banks may not be appropriate for Islamic banks. This gives rise to system risks of developing and using informational technologies in Islamic banks.

Legal Risk
Given the different nature of financial contracts, Islamic banks face risks related to their documentation and enforcement. As there are no standard forms of contracts for various financial instruments, Islamic banks prepare these according to their understanding of the Shari’ah, the local laws, and their needs and concerns. Lack of standardized contracts along with the fact that there are no litigation systems to resolve problems associated with enforceability of contracts by the counterparty increases the legal risks associated with the Islamic contractual agreements.

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