The State Bank of Pakistan has formulated Risk Management Guidelines for Islamic Banking Institutions (IBIs) with a view to further strengthen the regulatory framework in the area of risk management for IBIs.
In a circular issued to the Presidents and CEOs of Islamic Banks or Banks having Islamic Banking Branches it said these guidelines are based on ‘Guiding Principles of Risk Management for Institutions offering Islamic Financial Services’ issued by Islamic Financial Services Board (IFSB), and the same has been tailored keeping in view the regulatory regime of the SBP. However, these guidelines will be in addition to the various Risk Management Guidelines issued by SBP from time to time and IBIs will be required to comply with both sets of guidelines.
The central bank said these guidelines provide a set of principles of best practice for establishing and implementing effective risk management in IBIs. These guidelines set out fifteen principles of risk management and provide guidance for each category of risk, drawn from discussion on Islamic Financial Industry practices. These principles are applicable to credit risk, market risk, liquidity risk, operational risk, equity investment risk and rate of return risk.
These guidelines will further complement and enhance the current risk management regime of SBP by identifying and suggesting technique to manage various types of risks unique to Islamic Banking Institutions.
Since most of the IBIs in Pakistan are new entrants in the market, they are encouraged to put in place an effective risk management strategy right from the start based on the attached guidelines as well as other guidelines issued by SBP. These guidelines are flexible in the sense that IBIs can adapt them in line with the size and complexity of their business.
According to the guidelines, IBIs shall have in place a comprehensive risk management and reporting process, including appropriate board and senior management oversight, to identify, measure, monitor, report and control relevant categories of risks. The process shall take into account appropriate steps to comply with Shariah rules and principles and to ensure the adequacy of relevant risk reporting to the supervisory authority.
IBIs shall have in place a strategy for financing, using various instruments in compliance with Shariah, whereby they recognise the potential credit exposures that may arise at different stages of the various financing agreements.
IBIs shall carry out a due diligence review in respect of counter parties prior to deciding on the choice of an appropriate Islamic financing instrument. IBIs shall have in place appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrument.
IBIs shall have in place appropriate strategies, risk management and reporting processes in respect of the risk characteristics of equity investments, including Mudarabah and Musharakah investments.
IBIs shall ensure that their valuation methodologies are appropriate and consistent, and shall assess the potential impacts of their methods on profit calculations and allocations. The methods shall be mutually agreed between the IBIs and the Mudarib and/or Musharakah partners.
IBIs shall define and establish the exit strategies in respect of their equity investment activities, including extension and redemption conditions for Mudarabah and Musharakah investments, subject to the approval of the institution’s Shariah Advisor.
IBIs shall have in place an appropriate framework for market risk management (including reporting) in respect of all assets held, including those that do not have a ready market and/or are exposed to high price volatility.
IBIs shall have in place a liquidity management framework (including reporting) taking into account separately and on an overall basis their liquidity exposures in respect of each category of current accounts, unrestricted and restricted investment accounts.
IBIs shall assume liquidity risk commensurate with their ability to have sufficient recourse to Shariah-compliant funds to mitigate such risk.
IBIs shall establish a comprehensive risk management and reporting process to assess the potential impacts of market factors affecting rates of return on assets in comparison with the expected rates of return for PLS deposit holders.
IBIs shall have in place an appropriate framework for managing displaced commercial risk, where applicable. IBIs shall have in place adequate systems and controls, including Shariah Advisor, to ensure compliance with Shariah rules and principles.
IBIs shall have in place appropriate mechanisms to safeguard the interests of all fund providers. Where PLS deposit holders’ funds are commingled with the IBIs’ own funds, the IBIs shall ensure that the bases for asset, revenue, expense and profit allocations are established, applied and reported in a manner consistent with the IBIs’ fiduciary responsibilities.